The Ideal of Leveraging Vs. The Ideal of No Debt (Part 1)

There is no shortage of real estate investing advice that discusses the power of leverage in purchasing properties. Experts talk about how to buy houses with “low down payments,” or even “no money down.” It seems these strategies are sometimes touted because there is a larger market of people who will buy a book about how to get started investing with little money. After all, there are more Americans who barely have any money saved than the number of Americans who would buy a book about how to buy houses with, “cash savings over $200,000.” However, if an investor can borrow money at 4% and get a return of 14%, why wouldn’t that investor capitalize on using other people’s money and maximize profits?

ubanMeanwhile, there is another group of financial experts (Dave Ramsey being one of the leaders) who advise against having any debt at all, including real estate. The thinking from this group is, “Why lose 4-5% by paying interest to a lender when saving the cost to borrow can directly increase profits?” I find myself thoroughly understanding both sides of the argument, but unable to decide which approach is better.

Over the years it has become common practice in America for home buyers to take out large loans to purchase their abodes. The 30 year fixed rate has become the most popular type of mortgage. Traditionally, 20% of the sales price has been a benchmark figure for a down payment, although many homes loans are completed with down payments as little as 0-5%. Lending standards and down payment requirements fluctuate with the economy and various factors. Meanwhile, investment properties typically require at least 20% of the purchase price as a down payment, and the interest rate is about .5-1% higher than an owner-occupied home. But these numbers differ as well. Local banks and portfolio lenders who do their own underwriting can adjust the requirements. These “in house” lenders have more freedom to tailor an investment loan for the specific deal involved. For example, I recently heard about a lender in Nashville, TN who would finance investment purchases with only 10% down payment required for renovations and new construction projects.

Another common source of funds for investors can come from a home equity line of credit, often referred to as a HELOC for short. These types of loans can be especially appealing to flippers who may only own a home for 6-12 months or less. A 30 year fixed rate mortgage doesn’t make sense for quick deals, when properties are being bought and sold frequently. The HELOC incurs borrowing closing costs only once instead of individual closing costs for every deal financed. Rates for a HELOC differ depending on the amount borrowed, but aren’t dramatically higher than fixed rates for 30 year mortgages. Of course these loans are based on the fact that there is indeed sizable equity in the property held as collateral. Some large national banks will only offer a HELOC on a primary residence and not on an investment property, even if you own it free and clear. More reasonable lenders will gladly comply.

I’m taking a moment to discuss these loans to point out what has become “normal” in the real estate financing world. It is normal to borrow 80%, 90%, or even more of the purchase price of a property. It is normal to expect to have mortgages for 15 or 30 years, and that is if you stay in the same house. Many homeowners borrow as much as possible every time they move. In those instances, monthly housing payments may be made for 40- 50 years or even until death. The majority of Americans view this leveraging as normal. It should be no surprise that real estate investors often take on the same perspective. If investors buy their primary homes with the least down payment possible, why wouldn’t they buy their investment properties with minimal down payments as well?

I think a lot of people trying to buy their first investment property are focused on how to close the first deal. Like most Americans, they don’t have huge piles of savings, so they scrape together a down payment and get the keys to their first rental or flip. If the investor has goals of growing their portfolio, they try to duplicate the process a short time later. Similarly, the purchase is usually made with the least money out of pocket possible. For these types of investors, there may not be another option. They may believe that buying a property for cash isn’t possible, or that it would take many years of savings. For some individuals, that may be the case, but is that reason to go hundreds of thousands of dollars in debt?

Some investors seem to take pride in buying properties with none of their own money involved. There is a book titled, “How We Bought a 24 Unit Apartment Complex For (almost) No Money Down!” The same author, Brandon Turner, has another book called, “The Book On Investing in Real Estate with No (and low) Money Down.” Like I wondered earlier, are these strategies being offered because they make the most financial sense, or because they sell the most books?

Leverage is a powerful tool. The Adventure Science Center in Nashville has an exhibit where an average non-strong person can lift up a car by pulling down on a very long lever that is attached to the top of the car. By using an exaggerated lever, a person’s strength is multiplied. The exact same claim can be true in real estate. For example, if an investor puts down 20% on a $200,000 house, and the house doubles in value, a $40,000 outlay turns into a gain of $200,000, five times the initial investment. On the other hand, if the same house was purchased in cash, the $200k doubles, but only returns two times the initial investment. With this example, it is clear that leverage can produce greater results. Let’s say the investor in this scenario invests the $200,000 as $40,000 down payments on five different houses instead of paying cash for just one. Let’s pretend all five houses double in value at the same time. Now his $200,000 investment has produced $1,000,000 in equity. It is the same rate of five times the initial investment, but magnified by a greater amount. The larger lever allows lifting a car instead of just a bicycle, and the larger loan amounts can result in larger profits.

An investor to earning profits by using other people’s money is no secret, and has long been touted as one of the advantages of real estate compared to other investment options. But with the greater potential reward there also comes greater potential risk. Houses don’t always appreciate in the short term. They don’t automatically double in value every few years. If the local market depreciates by 10% in the example used above for a $200k house, the loss of $20,000 in equity per house gets multiplied by five houses. Now the investor has lost $100,000 in value. Many people used to believe that housing values would only go up. The Great Recession proved that to be a false belief. Additionally, if the renters fail to pay, and maintenance demands arise, the investor can find that the positives of being indebted for five properties doesn’t eliminate the negatives.

*Part 2 of this discussion will be posted tomorrow.