A few weeks ago I was speaking to a group of investors in San Francisco and I surprised many in the room when I made a statement that I did not believe you should buy real estate and leverage it for cash flow. Given that I am a partner in two companies that specialize in helping investors find properties that provide a positive cash flow after leverage, this statement caught much of the audience by surprise. But I followed that sentence with a bit of clarification. I told the group that there are many ways investors can be fooled or even fool themselves today into thinking that they are making a positive cash flow on a property and some of the biggest mistakes investors make is sacrificing long-term stability for short-term gains.
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When I purchased my first home, I was given one option by the three different finance companies I visited…a 30-year mortgage. The 30-year mortgage has become the staple of real estate investing and even Warren Buffet’s recent statement about the 30-year mortgage shook the real estate world. What many people fail to recall about Warren Buffet’s assessment of investing in real estate is that he used the phrase “…if he could…” which, is very different than stating “this is what I am dong”. But that is another story altogether. The point is that a 30-year mortgage has become standard and not only standard for what companies want to show, it has become standard for what investors want to see.
Many companies, who provide investment opportunities, including mine, will show a mortgage projection based on the 30-year mortgage. Why? Because it is what the average, every day investor wants to see. It is how we have been programed. A simple search of the Internet will return article after article extolling the benefits on using a 30-year mortgage, especially for the positive effects it has on an investors’ cash flow. When I first started investing, I was coached to use the 30-year mortgage as a tool to boost my monthly income while allowing a renter to pay down my note. One thing that I missed and subsequently had to be taught over the years from some investors much smarter than me, was that for the first 25 years of my ownership of that property, I would be paying more in interest payments than I was earning in cash flow. In the first 15 years it would be substantially more!
Owning Investment Real Estate Outright
Many homeowners and real estate investors will tell you that there is a simple strategy that makes a 30-year mortgage a good investment. You simply place a 30-year mortgage on an investment property and pay it off like it is a 15-year mortgage. Now I know that there will be some readers who will comment that yes, this is the precise strategy that they use and that they calculate each month exactly how much money to pay to reduce the principle each month. They feel that they get a lower rate since a 15-year mortgage can cost as much as .25 to a .50 point more. To those readers that follow this strategy and actually follow through on this strategy, I will say that I believe you are in the minority and congratulations! It takes tremendous self-discipline to be able to make that strategy work and I have met many investors who claim this will be their strategy only to find that they like bragging about higher cash flow more than they like bragging about owning the property.
For me, a better strategy that more and more investors that I am dealing with are employing is, using leverage to allow them to purchase more properties faster at today’s pricing, yet for-going cash flow for faster payoffs. Investors taking this route are usually financially secure and are not necessarily real estate investors. They see real estate as a secure investment and rental properties as a product that will have continued demand in the foreseeable future. They are using two different strategies to purchase the properties.
- They are purchasing property using a 15-year mortgage. They then take the cash flow each month and use it to reduce the principle. In some cases, this can reduce the term of the loan to less than eight years.
- They are structuring the term of the loan to match the monthly note to the rental amount received.
In both scenarios the investors are using leverage to increase their purchasing ability and using the cash flow produced to reduce the principle either faster than the term or in as short an amount of time as possible. They recognize that there is only one fixed expense that the investor can be in direct control of and that is interest. Management, taxes and insurance are all fixed costs which; the investor has little to no control over. Vacancy is a variable cost that even with the most prudent management is going to affect an investor at some point and there is nothing an investor can do to prevent. Routine maintenance and major replacement costs are also variable costs that, while an investor can prepare for and take steps to reduce, there is still little an investor can do to limit and nothing an investor can do to eliminate these costs. That leaves interest costs as the only major expense that an investor has control over as it relates to earnings potential on a property.
Many investors that I am talking to today are choosing to do everything possible to reduce the over-all costs of interest including choosing higher interest rates to secure shorter terms and buying cash flow properties not for the cash flow, but to purchase more properties faster. I want to make sure everyone caught that last sentence. While in San Francisco, this was a big point I was trying to get across to the audience and based on their reaction, it made sense to them.
How I Buy Properties
As an investor, I believe in buying properties that make sense based on what I have experienced as an investor. I have bought junk properties. I have bought “cheap” properties. I have bought properties and done the minimal amount of work to get them “rent ready”. I have bought properties with creative financing such as ARM mortgages and even bought a couple with interest only loans. Every one of those strategies was aimed at producing Higher Monthly Cash Flow. And every one of those strategies almost sunk me completely as an investor.
Today, I buy properties where the fundamental economics make sense. I told the crowd in San Francisco that when buying properties that produce a monthly positive cash flow, they should consider using that money to reduce principle. I cautioned them that if they were attracted to real estate and cash flow because they needed to pay bills, then, in my opinion, they really needed to be positive they were getting sound financial planning before buying. I told them that in my opinion, real estate purchased for buy and hold is a great way to build and maintain long-term wealth, but a lousy way to earn short-term money. I told them that real estate has the greatest pay-off when you own it outright and that as an investor, getting to that point should be your highest priority. Using leverage to build your long-term portfolio is a great tactic. Using leverage to build your short-term monthly cash flow is not.
Am I off my rocker? Am I spot on? Let me know what you think…
Photo: Kevin Dooley