One of my favorite conversations is with real estate investors sportin’ lots of capital who insist on paying cash for investment properties. They’re almost universally flabbergasted when I tell them they can do better in today’s environment by using a bit of leverage. When they ask me to prove it, I begin by asking them a couple questions.
Is the cash on cash return of their acquisitions important to them?
Are they investing so they’ll have future retirement income?
If their answer is yes to both, I then proceed to demonstrate — empirically — exactly how the ‘always pay cash’ strategy will sometimes produce significantly inferior results. Let’s be clear about how we’re defining results here.
The successful attainment of maximum retirement income through a strategy created to use the finite capital immediately available at any given time.
An investor has half a million bucks to invest with the above mentioned agenda in mind. His plan is to retire in 15 years — at which time he’ll be 65 years old. He finds a couple duplexes for $250,000 apiece. They’ll generate roughly $36,000 a year in income. (For the purpose of this post, we’ll use just the purchase price without closing costs to keep things simple.) They’re well located, new or newer, and have a strong demonstrated track record attracting quality tenants.
He’s excited. I tell him to look at what’s possible if he were to use a slightly different strategy. Rolling his eyes, he agrees. What could possibly beat the return provided by paying cash?
Let’s establish his cash on cash return generated by his all cash approach.
That return is calculated simply — divide cash flow by cash invested. In this example it’s $36,000/$500,000 = 7.2% — pretty straightforward.
But what if he puts 1/3 down payments on six of these duplexes? Today’s available financing allows him to obtain 30 year fixed rate loans sporting 5% interest. Let’s see what his cash on cash return would be.
$43,580/$500,000 = 8.7% cash on cash return. Don’t miss the fact that the cash flow in dollars has increased by $7,580 annually — a 21% increase in cash flow from Day 1.
He’s not rolling his eyes any more. 🙂
By using what I’ve come to call the Domino Approach, he’ll have used the cash flow from all properties to pay off one duplex at a time. It’ll take almost 3.5 years to free and clear the first property, but then he begins realizing the immediately increased cash flow and the velocity increases as each domino falls.
In less than 13 years — 12 years, eight months — he’ll be the proud owner of half a dozen debt free income properties. They’ll be spinning off about $108,000 in annual retirement income — well over two years before his scheduled retirement.
He’s also retiring with triple the income his plan would’ve produced.
I pointed out that in the process his actual cash flow and cash on cash return were much higher than if he’d applied his approach — from beginning to end.
It’s important to note that the NOI (net operating income) and the property values were not projected to increase — ever. Yet, look what also happened to his capital growth rate — then compare it to how his capital would have grow in his ‘all cash’ scenario.
In Year-0 he invested $500,000. 12.67 years later his equity was $1.5 Million. His capital growth rate was just under 9% (8.96%) Again, no appreciation was applied.
Year-0 — the same $500,000 invested. 12.67 years later his equity is the same $500,000. He literally has no capital growth. In fact, it can be credibly argued he lost money due to inflation.
Forget cash on cash — forget capital growth — just concentrate on the difference in retirement income he generates from each of the two strategies.
$36,000 as a result of paying all cash — $108,000 as a result of using moderate leverage.
It’s at this point I ask them to put me on speaker, and stand up. Then I tell ’em to extend their arms straight out, palms up, as if they were weighing different objects in each hand. Then to move each hand slightly up and down, as if determining which object is heavier. When they tell me they’re doing that, I recite the following, not making any effort to hide my glee. 🙂
“I dunno, $36,000…..$108,000 — which one do I want? That’s a poser.”
I won’t repeat what many of ’em reply to that. 🙂
BawldGuy Takeaway: When it’s possible to make use of positive leverage, i.e., the cost of borrowed money is less than your investment’s return, paying all cash is the inferior strategy. This is true for cash flow, cash on cash return, and the ultimate cash flow generated long term.
Paying cash for income property isn’t the slam dunk no-brainer so many folks think it is. Sadly, most of ’em won’t figure this out ’till they retire — if ever.
The most underrated task in the investment world is solid analysis. You can pay for it before you invest– or pay for it afterward, which will be the rest of your life.