Oh, the famous debate. Should you pay cash for your investment properties, specifically rental properties, or should you leverage them? If you are new and don’t know what leveraging means, it means using a loan or some other form of money (basically anyone’s money other than your own) to buy property. Buying a house using a mortgage is a perfect example of leveraging.
If you haven’t caught wind of this debate yet, just search for about five seconds on the BiggerPockets Forums and you should find enough entries about this to hold you over for hours! If you have seen these posts or been involved in the debate, you already know exactly what I’m talking about.
I want to start this article by making a very firm prefacing statement that I want to make sure everyone reads. And that statement is:
No matter what any analysis or argument suggests the better method to be — buying investment properties using leveraging or with all cash — the only route you should personally go is that which you are most comfortable with.
Here’s the reality of this debate. I think people get so caught up in the arguments flying back and forth that we forget to take a step back and realize that regardless of which method people prefer, we are all still incredibly awesome because unlike a lot of the rest of the world, we are buying investment properties! Buying investment properties is incredibly advantageous, a lot of people don’t have the nerve to do it, and irrespective of anyone’s methods as to how they do it, we are all investors and we have that in common. That should be acknowledged! That, and there is literally no right or wrong option for how you decide to buy your property. If one guy prefers paying all cash and another prefers leveraging, great! How another guy does it has no bearing on your investing, and neither option is bad or wrong.
How’s that for an opening? Everyone feeling all warm and full of smiles inside because you just realized we are all in fact part of this amazing community of really cool people? I know I am!
Now that everyone is feeling great, I’m going to detail my personal stance in the debate. I want to do a secondary preface here and say that my point in explaining my view on this is not to convince you it is what you should do. My point is simply to explain what I prefer for my own investing so you have something to get you started in thinking about what you may prefer for your investing.
You can love what I say, hate what I say, agree or disagree with it — all is fine by me. As I said, this is just the side of the debate I am more comfortable with, and it’s worked fantastic for me with my properties so far! That doesn’t mean you will be comfortable with it or that it will work for your properties, so I encourage you to decide for yourself which route you ultimately want to go (or even better, maybe you do both!).
Are you ready? Time for the big reveal! For all of my investment properties, I prefer leveraging. I will now explain why I prefer leveraging, and certainly if you don’t support leveraging and prefer paying all cash, be sure to give us your reasoning in response! The more input we get, the more educational it will be for everyone.
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An Argument for Leveraging Over Paying All Cash
I prefer leveraging for two main reasons, to be explained in more detail:
- The returns are higher.
- Risk is lower.
I can already hear some of you gawking at #2. Don’t worry, I’ll get to that one. I want to start with the returns though.
Returns on Leveraged Properties vs. Non-Leveraged Properties
My argument that leveraged properties produce higher returns than non-leveraged properties is based on three sources of “returns” that come with rental properties:
- Cash flow
In order to explain some of these, and to conclude this argument, let’s use a hypothetical property that is available for purchase for $100,000. Buying it outright will cost you $100,000. If you finance the property at 20% down, it will cost you $20,000. In real life there are fees attached to each method, but for now I’m going to keep it simple and leave those out (but be sure to include those in your real-life calculations). Also hypothetically, you have $100,000 to invest.
If you aren’t familiar with Cap Rates and Cash-on-Cash Returns, start by reading “A Definitive Guide to Understanding Cap Rates and Cash-on-Cash Returns.” This will explain the terms, what they mean, how they differ, how they are used, and how they are calculated. Ultimately, the Cash-on-Cash Return is going to be the most helpful to you in understanding the (cash flow) return on the money you invest. Cap Rates are helpful for some things, but for what we are talking about here, it’s the Cash-on-Cash Return that matters.
Now, a tidbit:
The Cap Rate and the Cash-on-Cash Return on a property will be the same if you pay all cash.
The Cap Rate and the Cash-on-Cash Return on a property will differ if you leverage.
The reason I bring up both of these terms, despite saying it’s only the Cash-on-Cash Return that matters right now, is because when you start shopping for properties, it is the Cap Rate that is more often advertised. Cash-on-Cash Returns often aren’t advertised because they are dependent on the terms of the loan, which can vary, and Cap Rates are irrelevant of loans.
In order to determine what (cash flow) returns you should expect on a property, you need to be able to calculate that Cash-on-Cash Return. But if you are paying all cash, you can save yourself a step and just assume it to be the same as the Cap Rate. The main driver in this is the number used in the denominator of the equation, which is the amount of money out of your pocket. So this will be $100,000 for the non-leveraged property or $20,000 for the leveraged property.
Do these calculations for yourself on any property you are looking at. For the properties I have always bought, and for the majority of cash-flowing investment properties, the Cash-on-Cash Return of a leveraged property will usually be significantly higher than that of a property purchased with all cash.
This will not be the case with a lot with the Texas markets, for example, which do produce good cash flow but on the lower end due to high Texas property taxes and insurance. But on properties that have good cash flow, the Cash-on-Cash Returns for a leveraged property can easily be double or more than that of a non-leveraged property. But don’t take my word for it, do the math yourself and see what you find.
If you need additional help on figuring out how to calculate Cap Rates and Cash-on-Cash Returns, check out “Rental Property Numbers So Easy You Can Calculate Them on a Napkin.”
In short, there are different sources or arguments around equity, but for simplicity, let’s just look at appreciation. Let’s say our hypothetical house bought for $100,000 in 2015 appreciates by $15,000 by 2016. If you bought for cash, you bought one house (because you only had $100,000 available to invest, remember).
You will then have experienced $15,000 in equity build due to appreciation. But let’s say you leveraged, so you were able to buy five properties instead of one ($20,000 each, which totals $100,000). If those houses experienced the same appreciation wave, by 2016 you have now earned $75,000 ($15,000 x 5 properties) in equity build. That’s a huge difference! In this case, the investor who leveraged now has 5x more in available equity than the cash-buying investor.
For anyone unaware of one of the biggest financial benefits of owning rental properties, I suggest you study up on depreciation. I’m not going to get into the details of it here, but it is a major write-off on your taxes for any rental property. Hypothetically, let’s say the depreciation write-off on this property in one year is $2,500. If you paid all cash and you have that one rental property, you will have $2,500 in total depreciation deductions. If you leveraged and bought those five properties, you will have $12,500 ($2,500 x 5 properties) in total depreciation deductions for the year! Another huge difference!
As you can see, and as you will see if you do some calculations on your own, in most cases the return on the money you invest and the amount of income in addition to just the cash flow will be higher when a property is leveraged. If you disagree with any of my math, certainly chime in and let me know your thoughts. But as far as all of the math I have ever done with rental properties tells me, leveraging a property produces significantly higher returns overall.
Risk Involved With Leveraging Rental Properties
I hate to point you in the direction of another side article, but I actually wrote a detailed analysis on this in a past article. I will summarize what I wrote there here, but if you do want to read all of the details, check out “Is Leveraging Really that Risky?”
What that article boils down to is: In my opinion the only thing at more risk by leveraging (at least through a reputable source, like with a mortgage) than by not leveraging is your credit score. If something were to go haywire with a property you have financed and you have to foreclose on it or short sale it or whatever, the only thing lost there will be some of your credit score.
Let’s look at it in this very simple way:
If you buy that $100,000 house outright and something goes horribly wrong, you will be out $100,000. If you finance that $100,000 house, and something goes horribly wrong, you will only be out $20,000. In that case, the bank loses way more than you do. So doesn’t that mean that essentially the bank assumes the majority of the risk on a property when you finance it? It absolutely does!
And the best part? While the bank assumes most of the risk, you still reap 100% of the rewards. The cash flow from the property, any equity built due to appreciation, extra income due to major tax write-offs… all yours! Again, yes, your credit score is at risk should something go wrong, but is your credit score really that life-threatening? Ummm… no. Sure, it’s very helpful and convenient to have a good one, but the world won’t end if something happens to it.
Some people argue that the danger in financing lies in the possibility of you not having the money one or more months to pay the mortgage. This has been a huge issue, people not being able to pay their mortgages, in our country over the past few years and arguably one of the reasons of the demise of the economy we just experienced — but remember, those statistics lie mostly with primary homebuyers who don’t have a lick of investing experienced and since banks were handing out mortgages like candy, of course people got in trouble!
But we are talking about real estate investors now. I would like to think we have a bit more education than all of those folks who bottomed out on their mortgages (we certainly have the resources at our disposal to help us with that education!), and by the time you buy your first rental property, you have enough of a head on your shoulders to:
- buy smart so the risk in not being able to cover your mortgage is very minimal (which strongly involves location, tenants, property condition and maintenance) and
- have a nice nest egg to cover any unforeseen emergencies.
If you have both of those things, the chances of you running into a problem so severe that you can’t pay the mortgage is quite small. But even if you do, remember, you will only be out that $20,000 (if even that much because you were collecting income on the property for all the time you had it), and your credit score will have a ding. Quite survivable.
So in summary of risk, the way I see it is: You’re either out $20,000 with a ding on your credit, or you’re out $100,000. I don’t know about you, but option #1 sounds much better to me!
Which Side of the Debate Are You On?
Well, now you have heard my personal stance when it comes to whether I leverage my properties or pay cash. I have always leveraged my properties, and I plan to continue doing so for all the reasons I mention.
But like I said, I don’t expect everyone to agree with me or suddenly feel comfortable leveraging. If you do prefer to pay all cash, or think it is the better route to go, please share any information with us you are willing to share in the comments! The more input, the more education everyone will have, and the more comfortable everyone can feel in making their decision.
As a slight rehash, neither way is wrong or right. They just are what they are, and everyone will have their reasons for which one they choose. I don’t personally believe paying all cash is the most lucrative or safe way to invest, but I won’t for a second tell anyone who does pay all cash that they are wrong or that they shouldn’t do it. The reality is, not everyone is comfortable leveraging!
So what is your stance? What are you most comfortable with?