This article was originally posted at hipsterinvestments.com in October 2012. See the original post here.
I was asked my opinion on whether someone should pay all cash for an investment property so they can borrow against it, or leverage it. I definitely don’t claim to be an expert, but based on my calculations and experience, I think leverage is the way to go every time. Two main reasons: 1. Your cash-on-cash return will be significantly higher, and 2. Your personal risk is less because you are using less of your own money and more of someone else’s.
After I bought my first rental property is when I got curious about this and sat down and did the math. I used that property as an example and calculated it with 20% down and a mortgage, and then with an all-cash buy. I don’t have my scratch paper handy to remember the exact numbers, but with this $55,000 house I bought, it had a cap rate of ~14%. If I bought the property with all cash, my cash-on-cash return = the cap rate, because the denominator in the equation is the same- the purchase price is how much I would have paid in cash. Then I recalculated everything assuming the financing, and the cash-on-cash return took a flying leap up to 32%. Woot! So my cash-on-cash return more than doubled. And isn’t the cash-on-cash return what I really care about if I want cash flow anyway? Cap rates are really only in relation to buy/sales price of a property, and while an indicator of how much cash flow you will receive (<7% not good, 7-9% good, >9% great), it doesn’t say exactly how much return on the money you actually put in you’re getting. The cash-on-cash return does. So while if I pay cash, it seems like I’m getting a lot more cash flow per month, which I am, but compared to how much money I had to put down to do that, I’m actually making a lower return.
Then for risk, I either put $55,000 of my money into one basket, or I only put say $15,000 into that basket. Which route has less risk to me? The one where I invested less of my money.
Lastly, using your investments to buy more investments. Let’s say you have $100,000 cash to invest. First example, the all cash buy. You pay $100,000 for one property. Then you pull out financing against it (the risk here is remember you may not be able to get the full $100,000 out of it, but for the purpose of this discussion we’ll pretend you do), and buy a second property. To keep it simple, we’ll stop here (but we all know the smartest thing to do is to just keep doing this over and over and buying more and more). So you’ve spent $100,000, you have two properties, and $100,000 in equity from the second property. Let’s say both of these are making that 14% cash-on-cash return from the example above.
Now, let’s use the same $100,000 and use leveraging. For a normal mortgage, you can get away with putting 20% down, so for that $100,000 property you only have to spend $20,000 (ignoring closing costs for this example to keep it simple). Well, you have $100,000, so that means you can buy five $100,000 properties. After putting down your 20%, you have $80,000 in equity in each property.
The results of the comparison? Both scenarios cost the same amount of money out of your pocket. The all cash buy bought you two houses, gave you $100,000 in equity, and gave you a 14% cash-on-cash return for cash flow. The leveraged buy bought you five houses, gave you $400,000 in equity, and gave you a 32% cash-on-cash return for cash flow. As if that isn’t crazy enough, don’t forget one other income avenue you have on any investment property you own- depreciation. The amount of money you collect from depreciation each year can be substantial. If you only own the two properties, you only get to collect depreciation on two properties. If you have five, you’re collecting on five! Five!!
So my overall opinion? Again, I don’t claim to be an expert by any means, but all I see is that if I use leveraging, I get:
– A higher return on my cash investment
– More equity that I can leverage against to buy more properties
– Less risk because all my eggs aren’t in the same basket
– A lot more cash in my pocket from depreciation on my taxes
I don’t know about you, but…