The Pros and Cons of Leveraging vs. Paying Cash for Indianapolis Rental Properties
I know a lot of people will read the headline of this blog and move right along to something else.
Because, in reality, there’s definitely a segment of investors – particularly new investors – who aren’t in the position to actually pay cash for an investment property… at least an investment property that’s habitable and in a respectable area.
But, for those of you in the position where you could pay all cash for an investment home, I’m sure you’ve debated the idea of paying cash, or using a mortgage – leverage – to help pay for the property.
This is a long-standing debate in the investment world and one that really doesn’t have a magic bullet answer.
At the end of the day, the answer all comes down to your personal needs and wants and what makes the best sense for you as an investor.
So, I thought I would spend some time discussing Pros/Cons of both and also talk about how we’ve used both over the years during our investment ventures.
Pros of Paying Cash for a Rental Home
- Initial Cost Savings – Mortgages aren’t free. If you’ve ever bought a home, you know the various fees involved with obtaining and closing that loan:
- Origination Fees
- Processing Fees
- Underwriting Fees
- Appraisal Fees
- Recording Fees
- Discount Points
In Indiana, you can expect to pay around $2,000 to simply obtain a mortgage. Obviously, if you pay cash, you eliminate all these costs.
- Initial Time Savings – Not only are mortgages expensive, they can also take a lot of time, particularly with all the heightened underwriting requirements. We generally plan on 45 days from the time an offer is written until the closing can occur. Most of the time needed is to simply get the loan approved and funded.
If you are like most investors, you want to get down to business quickly. A cash closing can occur very fast – in a matter of days in some cases, which will allow you to begin your project much faster.
- More Attractive Offers – Sellers like cash offers, particularly any seller who has had to deal with low appraisals or deals that have blown apart because of underwriting problems. All things being equal, your offer will likely be chosen if you come in with cash and competing offers have mortgage contingencies.
Note: Don’t expect sellers to necessarily take less of a net profit from your cash offer. A mortgage doesn’t really “cost” the seller anything, so the net is the net. But, in some cases, and with some sellers, your cash offer will win out.
- Better Monthly Cash Flow – Not only will paying cash save you the initial mortgage expense, but you will also never pay mortgage interest each month, which will increase your monthly cash flow potential. As you know, the majority of a loan payment during the first several years will go toward mortgage interest. While this interest can be tax deductible, it’s still a hit to cash flow.
Cons of Paying All Cash for a Rental Home
Paying all cash can essentially place one very large egg in your investment basket. For example, if you have $100,000 to invest, and you invest it all in one property, you take on some risk. Not only are you 100% in real estate, you are 100% in one specific neighborhood in one specific city in one specific state. If that neighborhood were to fall into disfavor (it does happen, trust me) you have a lot to lose. While you reduce your risk if you pay cash for multiple properties in different areas, it’s still a lot of money tied up in one single investment.
Pros of Financing (Leveraging)
- Less Funds Needed. Obviously, if you buy a $100,000 house and you pay cash, you’ll need at least $100,000 to make that happen. If you leverage the investment, you’ll need much less. Most lenders like to see investors put down 20% of the purchase price. In that case, you’ll need to come up with a $20,000 down payment, considerably less than paying cash.
- Greater Buying Power. If you are like most investors, you have limited capital to invest. Let’s say that you have $200,000 in savings that you want to invest in real estate. If you choose to buy properties in the $100,000 range, you’ll be able to buy two properties if you pay cash. If you leverage, you’ll be able to buy 10 properties, assuming a 20% down payment. That’s obviously a massive difference.
Cons of Leveraging
Any investor who was involved in real estate during 2007-2008 knows the risk of having a mortgage. Foreclosures still happen every day, but they happened en masse during that time. Property values plummeted, sub-prime mortgage rates skyrocketed, and many investors, particularly those who probably weren’t prepared to be investors in the first place, lost their properties.
Any mortgage has inherent risk. If you choose to leverage, make sure you prepare yourself accordingly.
Our Rental Homes – If you’ve spent any time on our website, or read other blogs of ours, you’ll know that my business partner and I own a decent amount of rental properties.
And, we chose to use mortgages for all of these properties.
Well, “chose” probably isn’t the best word. When we first started investing, we didn’t have a choice. We started buying in our 20’s, when we had very little money to invest, and used the power of leverage to acquire many properties. Lending practices were, by today’s comparison, very loose. In some cases, we only had to put down 10% as a down payment, which allowed us to buy a lot of homes with relatively little cash out of pocket.
We started with the idea of buying one home a year. But, after we bought the first home, and had some good success with it, we started buying around one a month for a while. We kept our lender busy, we used investment savings for our down payments, and we built a nice portfolio of single family and small multi-family properties with not a huge amount of capital investment.
Now, 17 years after buying that first property, the power of leverage has worked its magic for us. While being a Landlord has been a grind at times, we’ve used our Tenant’s rent money to significantly pay down our mortgages, benefited from all the great tax benefits real estate provides, and have seen some nice appreciation with most of our homes.
The bottom line is that we could have never achieved this kind of success without leverage. It was our only solution and, as it turns out, our best solution as well.
Flipping Properties – We are still actively buying properties to buy, rehab and sell. We used to do a decent amount of volume several years ago. However, with fewer foreclosures available and more and more competition, we now have a hard time competing in that arena.
When we do get lucky and buy a flip candidate, we always pay cash. The main reason is that the Marion County Sheriff Sale requires cash at purchase. But also, since our time frame to sell the home is generally short, we don’t want to incur the extra cost or waste the additional time that amortgage requires.
So, if you want to maximize your return on homes you flip, cash is definitely the best option.
What’s Your Best Solution?
Again, your best solution will depend on your specific investment goals. But, here are some general thoughts that you may find beneficial. Keep in mind that we are not financial advisors, and we encourage you to discuss your long-term investment goals with your financial advisor.
Young investor with a long-term perspective – If you are relatively young (I’ll let you decide what that means) and plan on being in real estate for a long time (at least 10-20 years), I suggest using leverage to buy your homes.
It will be difficult at times. You’ll question why you bought real estate to begin with. But, in most cases, you will build wealth without a large capital investment.
Older investor with a short-term perspective –
We represent a lot of near-retirement or retired investors who have decided to invest in real estate and generally use cash. In some cases, these are self-directed IRA products.
In many cases, these investors have a 5-year time frame, where they hope to buy, earn some cash flow along the way, and sell for a profit. Using cash eliminates the up-front cost of a mortgage and provides the opportunity to greater cash flow since there’s no mortgage.
Warning: Even if you pay all cash and, therefore, should have a greater chance for positive cash flow, DO NOT count on a consistent cash flow stream each and every month. This is something we preach to all of our customers… there’s no guarantee in real estate. If you need a new roof, a new HVAC system, or suffer an eviction, for example, you will have a cash flow issue.
In closing, whatever method you choose to buy your investment property, you’ll be fine. The most important decision is made when you decide to actually purchase an investment property. How you choose to finance it, in the whole scheme of things, is secondary.