By Douglas Katz – 11/02/23
The real estate investment world often debates the merits of leveraging properties through financing versus buying them outright with cash. Both strategies have their own unique advantages and disadvantages. In this article, we will explore a fresh set of examples to compare the benefits and drawbacks of using leverage and cash to acquire new investment properties. By examining these factors, you can make a well-informed decision that aligns with your investment goals and risk tolerance.
Advantages of Financing Investment Properties
Imagine you have $200,000 to invest in real estate. With access to investment property loans requiring a 20% down payment, you have two options: either purchase one $200,000 property in cash or buy five $200,000 properties with a 20% down payment on each. By spreading your investment across multiple properties, you reduce the risk associated with individual properties. This diversification can help safeguard your investments against unexpected market shifts, maintenance issues, or problematic tenants.
Financing enables you to expand your real estate portfolio at an accelerated pace. If you put a large portion of your capital into a property, that money is tied up until you sell or refinance. Those funds are stranded until such time as you refinance or sell the property. Using financing on one or more of your properties keeps those funds in play. With a mortgage, you can acquire properties more quickly, capitalizing on tax benefits, property appreciation, and rental income that grows in line with your expanding portfolio.
Real estate investments are often characterized by a lack of liquidity. Purchasing a $200,000 property with cash ties up your funds, limiting your access to that capital. However, by financing a portion of the purchase price, such as $40,000 on a $200,000 property, you maintain better liquidity. This allows you to use the remaining $160,000 for other investments, unforeseen expenses, or future financial opportunities. In my experience, capital crunches force investors to use quick and often more expensive means to fill the gap.
Inflation Works in Your Favor
Leveraging investment properties can provide a hedge against inflation. Suppose you take out a 30-year investment property loan with fixed monthly payments. Over time, your mortgage payment remains the same, while rental income typically increases annually, often exceeding the inflation rate. This leads to a growing spread between your rental income and mortgage payment, enhancing your overall profitability.
The place that this really manifests is when an investor ends up needed to tap equity to free up capital for other reasons. The terms of any transaction are based on the market conditions at the time of the transaction. If rates have increased, they cost of that loan will increase in kind. Basically, you would end up paying more for the money than if you had financed it in the first place. Financing from the start means that you are covered. If rates drop, you can always refinance.
Leverage Amplifies Your Returns
The term other people’s money can sometimes take on a negative connotation, but Consider a $200,000 property with a market rent of $2,000 per month and non-mortgage expenses totaling $800 per month. If you buy this property with cash, your monthly cash flow amounts to $1,200, totaling $14,400 per year. This results in a 7.2% return on your investment.
Alternatively, if you opt for a 30-year investment property loan at a 5% interest rate, financing $160,000 of the property’s value, your monthly cash flow drops to $400, totaling $4,800 annually. However, since you only invested $40,000 in cash, your return on investment improves to 12%. Keep in mind that leverage can also magnify losses if you invest in a property with negative cash flow.
Mortgages offer tax advantages for real estate investors. Landlords can deduct mortgage interest on all rental property loans, reducing their overall tax liability. While this doesn’t eliminate expenses entirely, it significantly mitigates their impact on your bottom line. For example, if you pay $10,000 in mortgage interest in a year and the deduction saves you $4,000 in taxes, your effective cost is only $6,000.
Advantages of Buying Investment Properties with Cash
No Risk of the Deal Falling Apart Due to Financing
When you purchase a property with cash, you eliminate the risk of the deal falling apart due to financing issues. When push comes to shove, the seller does not care where the money comes from. They love investors with cash because they are more likely to get paid. That is also long as they have proven out that the buyer has funds. This can be especially beneficial in competitive markets or when buying properties at auctions, as it ensures a seamless and secure transaction.
Better Negotiating Position
Cash buyers hold a significant advantage in negotiations. Sellers often prefer cash offers because they are more likely to close quickly and with certainty. Look at the current residential market and you can see how this has an impact, especially in competitive times. I have seen situations where cash was the only type of financing that a seller would accept. This is the extreme, but it is not insignificant and, in normal markets, sellers may be willing to accept lower prices from cash buyers, providing potential savings and better investment opportunities.
No Lender Fees at Settlement
Avoiding lender fees, such as origination fees, can save you thousands of dollars when buying properties with cash. Many lenders in the investment market are primarily compensated through points on the loan. In some cases, These fees can quickly add up, making cash purchases more cost-effective.
Loans come with the requirement to pay interest. Lenders need to make a profit on the money that they lend to you and charging interest accomplishes this by compensating them for the capital tied up in deals that they fund for you. When you buy with cash, you eliminate interest payments entirely. Over the life of a loan, interest can amount to a substantial sum, making cash purchases more economical in the long run.
Better Cash Flow, Less Labor
For rental properties, cash flow is typically the goal. A property should be in the black to make it a worthwhile investment. Interest and other financing related expenses can tip the scales toward negative cash flow. Cash purchases result in higher monthly cash flow because there are no monthly mortgage payments. This not only increases your income but also reduces the work required to maintain your properties, especially as you approach retirement. In some cases, paying cash can make properties that would not cash flow to an acceptable level if financed to make sense as a cash purchase.
No Risk of Properties Falling Underwater
Like cash flow, loan-to-value is a good barometer for evaluating project. The viability of a loan for the acquisition of or the later refinance of a property. Market conditions can cause the value of property to drop where the loan amount is greater than the property value. This can cause a host of issues that can cause issues. Purchasing properties with cash eliminates the risk of properties becoming “underwater” – worth less than the loan amount. High loan-to-value ratios increase this risk, which is entirely avoided when you use cash.
Cash or Leverage – Two Great Options to Grow Your Real Estate Portfolio
The choice between leveraging investment properties through financing and using cash for purchases should be based on your investment objectives, risk tolerance, and financial situation. Both strategies offer distinct advantages and drawbacks. Financing enables diversification, faster scaling, better liquidity, inflation hedging, and amplified returns. In contrast, cash purchases provide security, negotiating leverage, cost savings, improved cash flow, and eliminate the risk of properties going underwater.
Ultimately, the decision should align with your specific investment goals and circumstances. Careful consideration of these factors will help you determine whether financing or cash purchases are the right approach for your real estate investments.