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When used properly, financial leverage can be one of the most powerful tools available for accelerating your wealth building velocity through real estate.
The discussion around financing often gets muddled and becomes confusing because too many people fail to distinguish between different types of “debt” and think that all types of debt are bad.
It is true that consumer debt is almost always bad. Leaving revolving debt on your credit card is a quick route to wealth depletion because you are paying high interest on the money you borrowed, and the items you bought are not making you money to cover that interest. In fact, the items you bought are probably either gone (vacations, groceries) or are rapidly declining in value (your TV, countertop appliances, etc.).
Financing an investment property that is bought correctly, on the other hand, can be one of the most effective ways to increase you wealth building velocity.
Maverick was speaking to a client this week that has $100,000 to invest in real estate. He qualified for a conventional mortgage at 80% financing with 20% down.
The properties he is looking at have an average purchase price of around $100,000, so he was wondering if he should pay cash for 1 property or use financing and buy 4 properties.
Let’s first take a look at how tax benefits and appreciation potential might vary. If he were to buy 1, he would put up all the money for the purchase himself. If the property appreciated in value at 5% a year, then 4 years from now it would be worth just over $120,000.
When he takes the tax benefit of ‘depreciation’ on this property (assume he subtracts the value of the land from his purchase price and determines his property structure is worth $70,000, which he can depreciate over 27.5 years), he gets about a $2,500 “phantom loss” each year that he can write off against his real estate income (and possibly other forms of income if he meets certain criteria). Over 4 years, that is $10,000 in tax deductions.
Now, if he were to finance the purchase instead and put only 20% down, he would still get 100% of the appreciation and 100% of the depreciation deduction, but he only had to come out of pocket with 20% (plus closing costs) instead of 100% of the purchase price.
So, if he were to finance and buy the 4 properties instead of 1, then for the same amount of money out of pocket, his total depreciation deduction for 4 years jumps up to $40,000 and his total appreciation gains (if the market went up 5% per year) would be over $80,000.
When you finance your purchase, your mortgage interest is also deductible, so that would be an additional write off on top of your depreciation. A 30-year fixed rate principle and interest loan is “amortized” over 30 years, with the majority of the interest being paid up front and the majority of the principle being paid later. If you were taking out an $80,000 loan (80% loan on a $100,000 property) at 5.5% interest as an example, your monthly principle and interest payment would be just over $450/mo. On a regular amortization schedule at least $365 of the $450 payment would go to interest at the start of the loan and the rest to principle. Those numbers would then gradually adjust to more principle and less interest each year over 30 years.
That means that, in this example, during your first 4 years of owning the property you would have paid just over $17,000 in mortgage interest that you could deduct against your income from the property. So, if our client chose to finance and buy 4 properties instead of 1, he would have about a $56,000 total deduction for mortgage interest over the first 4 years.
Let’s say you get a 30-year fixed rate principle and interest mortgage on your property. That means that each month you pay down part of your principle balance, building equity in your property. Since you are going to buy right— meaning that the gross market rent covers all your expenses relating to the property, including your mortgage payment, even after you account for vacancy and maintenance loss—then your mortgage is ostensibly being paid down by your tenant each month.
So, in addition to any market appreciation that may occur to raise the value of your property, you are also making money each month on the other end by reducing your principle loan balance and building your equity.
In our example here, in the first 4 years over $4,500 in loan principle would be paid down. (And remember over time, a higher percentage of each payment goes to principle and a lower percent goes to interest). So, if our client decided to buy 4 properties with financing, this would be $18,000 in total principle pay down (equity build up) over the first 4 years.
Now it is time to talk about “cash flow”—your passive stream of income generated by the property (gross rent minus all your expenses associated with the property) that flows to you each month without you having to work for it.
When you get a mortgage, your total monthly expenses go up because you now have a mortgage payment to make, and your total net monthly cash flow goes down because you had to use some of your gross rental income to pay your mortgage that otherwise would have gone into your pocket if you had bought the property for cash.
HOWEVER, since you put so much less money down out of your pocket (in our example 20% instead of 100%), then your “cash on cash return”—the return on the actual money you invested out of pocket—can often increase substantially. Let’s have a look at our two scenarios above.
Let’s say the $100,000 property mentioned above gets $1,100/mo in rent and that you paid all cash for the property. So, the $1,100 per month comes in and after you subtract property taxes, insurance, property management fees, homeowner association fees if any, and you build in an assumption for maintenance and vacancy, let’s say your net cash flow estimate comes out to $750/mo. If you paid $100,000 for the property plus closing costs then that comes out to around 8.5% cash on cash return. Not bad. And that is just taking into account the cash flow alone, none of the other benefits discussed above.
But, now let’s say you financed instead and took out a mortgage at 5.5% interest so your mortgage payment is about $450/mo. That means that your net cash flow that goes into your pocket is knocked down to around $300/mo. But remember, you only put 20% down (plus closing costs), so your cash on cash return jumps up to about 14.5%!
Another way of looking at is to say if you bought 4 of the same properties with leverage, your net monthly cash flow in total adds up to $1,200/mo ($300/mo x 4 properties) compared with your net cash flow on the 1 property purchased for cash which is $750/mo.
If you take out a mortgage on your property, the bank that loaned you the money will place a lien on your property to protect their interest until the loan is paid off. If you get an 80% loan on the property, that means you only have 20% equity in the property compared with 100% equity if you had paid cash.
When you get a mortgage the property becomes “encumbered” and the bank is in 1st position, which means they have the first right (after the government for unpaid property taxes) to your property until the loan is paid off. Hence, your property becomes a much less desirable target for a lawsuit compared with a property owned free and clear with 100% equity and no liens.
Residential investment property is the ultimate hedge against inflation. A 30-year fixed rate mortgages is one of the greatest tools to not only protect yourself from inflation but to actually profit from inflation.
In our example above, you would be borrowing $80,000 per property (total of $320,000 on 4 properties) in today’s “real dollars” and paying it back (with your tenants rent money) over 30 years. Since the rate and monthly payments fixed, you get to pay your loan back over 30 years with “nominal dollars” that are not adjusted for inflation.
As inflation rises and the value of the dollar decreases, you continue to pay back the loan in diminished future (nominal) dollars instead of inflation-adjusted (real) dollars.
The difference between the value of the real dollars you borrowed and the diminished nominal dollars you are paying back is how you profit from inflation.
Now, let’s review our 2 scenarios in light of all 6 benefits and compare the options:
Use $100,000 to buy 1 Property for Cash and hold for 4 years (with all assumptions above):
Use $100,000 to buy 4 Properties with Financing and hold for 4 years (with all assumptions above):
Which option do you think our client chose? Which one would you choose?
We are not legal, tax, or financial professionals. The content on this page is for informational purposes only and should not be construed as individualized advice. It is your duty to consult with your own tax, legal and financial professionals about your individual situation, applicable laws, and the suitability of any investment property for you personally. All real estate investing involves risks, which buyer assumes, and no specific returns can ever be guaranteed by anyone.
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