The Ideal of Leveraging Vs. The Ideal of No Debt (Part 2)

While writing Part 1 of this discussion, I quickly realized how lengthy it could become. The problem is that there are so many details and variables to consider in this debate. From monthly cashflow, to opportunity cost, to tax implications, the analysis gets complicated. I read through a very thorough article about a similar debate to “Pay Off Mortgage Early Or Invest” on the Financial Mentor site. Many of the points raised in that article are relevant to ubanthis discussion, although that debate is about paying off the primary residence mortgage early or investing that extra money into a low-cost index portfolio. The debate I am having here is whether it is better to leverage investment properties and borrow as much as possible, or have no debt. Of course there is a very large range of options in between the two extremes, but if one extreme is indeed better, then wouldn’t it make sense to maximize it to the fullest?

The number one argument I make for the “borrow” camp is the power of leveraging purchases by using other people’s money. I gave an example in Part 1 of the difference between owning one home or five homes that double in value. That was showing the power of leverage when appreciation takes hold. But even if an investor’s properties gain little or no appreciation, they can still make money through the monthly cash flow. If I can borrow funds at 4%, invest in a rental house, and get a return of 14%, doesn’t it make sense to borrow? Let’s apply those numbers to a $100,000 loan. The difference between the cost of borrowing (4%) and the return of the investment (14%) equals 10%. Calculated annually, it equals a $10,000 profit. Simple enough. So isn’t it sensible or even advisable to do this over and over again? In other words, let’s buy ten houses that perform the same way. Now we have $1,000,000 in debt, but earn $100,000 a year.

This example sure makes it appear brilliant to borrow again and again. But is it really the better plan, or are most investors borrowing only because they need to in order to grow their real estate portfolios?

What if you have ten million in cash? Are you going to buy properties outright, or still borrow? It seems hard to imagine an investor with $10 million in the bank applying for a mortgage to buy a $100,000 house. Why does that seem almost absurd? If the same strategy that harnesses the power of leverage appears to be optimal, why would it be abandoned just because of the presence of more cash on hand?

I think we all know that debt comes with risk. There are strings attached. Owning something free and clear just feels better. And that is the leading argument for the “no debt” camp.

Paying for a property in cash allows for several benefits. First off, the owner isn’t paying interest on the loan. This is an automatic savings of 4-5%. While that may not seem like a huge savings, if interest rates rise to the 7% range, it will be more substantial. The higher rates go, the more the advantage of paying cash is magnified. Investors who have no debt also receive much greater monthly cash flow from each rental property. Every rent check can be deposited straight into the bank, without the mortgage payment that siphons away a large portion of the income. Of course the property owners are still responsible for the annual taxes, insurance, and required maintenance, but those costs are small in comparison with twelve mortgage payments. The third advantage comes from being in a better position to handle the unexpected “bad thing that happens.” Whether the heat goes out in the middle of winter, the tenants disappear and leave your unit vacant, or the local housing market tanks, it is much easier to get through the “bad thing that happens” when you don’t have a large mortgage payment or a mass of accumulated debt. You have more room to handle that risk of owning investment property, when you don’t have the additional risk of being in debt.

I had a conversation with a guy who wanted to get into real estate investing. He believed you had to have at least ten properties to really make any decent money. I knew right away that he was assuming each house would only make about $200-300 per month in positive cashflow. And perhaps he was right. It would take ten properties to equal $2,000-3,000 a month in income if they are mortgaged as much as possible. But it may only take two or three houses owned free and clear to equal $2,000-3,000 a month. Few would disagree that it is much easier to own three houses than ten. There are less roofs, appliances, and heaters to replace. And less properties and people to manage.

 “If I knew where I was going to live for the next 5 years or 10 years, I’d buy a home and I’d finance it with a 30 year mortgage. It’s a terrific deal… If I had a way of buying a couple hundred thousand single-family homes… I would load up on them. And I would take mortgages out on them at very low rates…”– Warren Buffett

Real estate investors have had a long-running love/hate relationship with debt. It is the tool that helps many succeed, and also the noose that ends many investing careers. Whether to use it and how much depends on the individual. It can speed up the process of building a portfolio, and also speed up the demise of one. At what point is it more important to have more debt and more income? At what point is it better to have no debt and less risk? No debt and more freedom?

The best approach for some investors may be found in that gray area between the two extremes. I think it is possible to find a balance where some debt can be helpful to acquire special opportunities that become available. Rather passing on a great deal just because cash is tied up elsewhere, credit can keep the purchasing door open for business. A HELOC is perfect for that situation. I believe it is important to keep debt at a low limit, where it is manageable and can be paid off at any point. If the debt ratio gets too high, it can cause investors to become cash poor and make unwise business decisions. Some examples would be selling a property for less than what it is worth because of a deadline, or losing a quality tenant from not being able to afford repairs on a rental.

I find myself drawn to both ideals. I see the allure of buying more properties, leveraging my way to a larger portfolio. But I don’t want to own thirty properties. I don’t need to. If I have excellent performing paid-for houses, I can get by just fine with six or seven. It seems that one of America’s beliefs is that small businesses should automatically try to grow into large businesses. But growth isn’t automatically good. I don’t want the hassles of owning thirty properties, so I don’t need to or want to maximize debt. Instead, I will grow my business carefully and conservatively even if it is slower than other investors. And I will enjoy the process with less worry and more freedom along the way.