A popular author and radio personality espouses paying everything off and becoming debt-free. This is an excellent strategy for some people but not for everyone. This blog will go another route, the one taken by most of the wealthiest real estate investors, the use of leverage.
You should know who this popular author is talking to and it’s not to you if you want to become wealthy at a fast pace. Most people have difficulty managing credit. If they have a credit card they use it. They buy cars and other things on credit. Payments and interest take a big chunk out of most people’s monthly budgets.
This blog is not written for anyone with credit management issues. If you can not manage your credit well, you should not consider becoming an investor. Seek help from others who have solved their credit management issues before considering any type of investment.
Do not carry balances on credit cards
Where I agree with him that you should not carry balances on credit cards. Interest rates are far too high and there are few exceptions where you can “borrow” from a credit card and earn more than you are paying in interest.
I also agree that you should pay cash for cars, RVs, and other large purchases if you have the funds. Do not buy what you do not need. So far we are on track with each other. Where I differ with him is on two points, one is paying off your house and the other is paying cash for residential rental property.
This blog is basically about residential rental investment property and leverage but I want to digress for a moment about your principal home. Interest rates for good credit are in the 5-6% range.
It makes no sense to pay off a house in a 5% interest environment
It makes no sense to pay off a house when the cost to own the house at 5% interest is so low. If you have the money to pay off your house, use it to invest in a rental property where the return is much higher than the interest you are paying on your house. Read on to connect the dots.
The concept of leverage is to borrow capital from third parties at low-interest rates and use the funds to earn money charging in effect higher interest rates. View your investment in residential rental property as if you have purchased a stock and the stock is paying dividends as well as potentially appreciating.
People who understand the stock market buy on margin which means that they are b, borrowing money from the brokerage house to bet on stocks. There is substantial risk in doing this and for that reason, many people leave this type of investing to the experts. Regardless it is a form of leverage.
Use other people’s capital to make money
The idea is the same, use capital to make more capital by paying the lowest cost to obtain the capital. This is called “leverage”. The following chart indicates an example of how leverage is used.
The example above starts with a property purchased for $100,000. The first line indicates that this property was purchased and financed with a 20% down payment of $20,000. The property earned $12,000 during the year in rental income ($1,000 per month). Divide the $12,000 income into the cash investment of $20,000. This is a 60% return.
, Please understand that the gross income is not profit. There are other calculations to determine profit and this will be explained in another chart. As you can see, the second line indicates a cash purchase, and using the same rent, it yielded a return of 12%. 48% lower return than the purchase made with borrowed money.
The example goes on to indicate that rather than use the $100,000 to pay cash for the property, that same amount could be used to buy a total of five properties each yielding 60% annually. The total income for all five for one year is $48,000 rather than $12,000 for one property.
Leverage has more risk than a cash purchase
The example above as mentioned is an extremely simplified look at the basic concept of leverage. There are of course more risks with leverage. What happens if the tenant does not pay the mortgage? If you own the property without a mortgage, you simply lose the income.
Proper planning and managing the residential rental property as a business will help mitigate risks. Owning more properties will help spread out risk in your portfolio. If one tenant does not pay rent, the other probably will.
I ran a scenario through an analytical tool to show you some real numbers. A property was financed with 20% down with a 4.5%, 30-year mortgage. Based upon the prevailing rent, the cash on cash return was 9.2%
The same property without a mortgage yielded a 7.5% cash on cash return. Even more interesting was the five-year return on investment analysis. The first scenario with a mortgage yielded a 75% return for the full five years.
75% ROI vs a 37% ROI, which is better?
The second cash purchase yielded a 37% five-year return. Which return would you rather have? If you are not risk-averse, you can save for years to purchase your residential rental property. Of course, prices go up and so do interest rates.
You could be chasing the potential investment, unable to save enough because of the moving price and interest rate target. Or, you can finance the property with a much smaller investment now rather than later.
If it takes you an additional two or three years to accumulate sufficient funds to pay cash, the price of the property will probably increase. Buying now (assuming you have found a good investment) using leverage may benefit you more than trying to save and pay cash.
Caveats
So here are my caveats to be considered after reading the above.
- Never take on more debt than you can afford to support
- Never settle for a mediocre return on investment, push the envelope, and wait for the right property to come along.
- Have lots of available credit, upwards of $100k on credit cards.
- Pay off your credit card each month.
- Spend as much as you can of your budget on a credit card and gain points or money.
- Make the minimum down payment on an investment property.
- Ask for owner financing at reasonable interest rates to reduce the number of mortgages showing on credit reports.
- Never invest in property when the COC and ROI are lower than you can earn on investments of the same risk e.g. bonds.
Finally, the information provided here is the opinion of one person. Do your research. You should never rely on the opinion of a single source when investing your money.
Several other blog articles on this site may be of assistance to you. We are in the development stages of creating a complete course on how to invest in residential rental real estate. Please check back with us.
