Free and clear vs leveraged

[Tim Moore]

Hey guys, so I keep flip flopping on how I want to structure my real estate business plan in the future. We always talk about "good debt" on BP and I understand that you can use the properties you have to leverage into more properties, but wouldn't your cash flow be much higher if you had it entirely payed off? Part of me wants to pay everything off as quickly as possible because I don't have dreams of being a billionaire or anything. I want enough passive income to supplement mine and my wife's W2 jobs so we can focus on what we love. Does paying off your mortgage not change the cash flow as much as I'm assuming it would or what? Help me out here and let me know what you think about free and clear vs leveraging your properties to get more. Thanks BP!

[David Faulkner]

Good question ... you will likely get lots from the pro leverage as high as you can all the time camp here on BP. Here is how I think about it and have done it. I prefer to acquire property all cash because it gets me the best chance at larger discounts, especially on distressed properties that can't be financed for one reason or another. I then typically remodel them, add value and fix whatever was preventing them from being financed, rent them out, then cash out refinance to give me money for the next deal. I did that for a good while to build up my portfolio, though I still was conservative keeping my LTV lower than most and growing a bit slower yet steadier than others. This strategy really paid off in 2009 when many folks that were over leveraged lost it an I had extra margin to see me through without a scratch and even more to take advantage of RE fire sale prices. So, I tend to be more leveraged in a bad market when there are more and better buying opportunities and less leveraged in a hot market where buying opportunities are few and far between ... it is that whole be greedy when others are afraid and afraid when others are greedy mindset sort of thing ...

Now, as my portfolio grew to a point beyond which if I had all the properties paid off the resulting cash flow would support my expenses plus reasonable margin (which is 2x for me) ... ones I hit that point, I "flipped the switch" from growth mode (with leverage) to capital preservation mode (free and clear) and as result started plowing all my cash flow and new contributions into paying off those mortgages in snowball fashion. My rationale is that I already have control over all the assets I need to sustain me, so I know longer need the growth, and any more over that only adds risk and headache for no additional marginal benefit.

Also, I preferred to invest in higher quality properties ... yes the price points were higher and the day one cash flow was lower, but the rents are also higher and the quality and consistency of the cash flow is higher, with far fewer headaches, and rents and prices in these neighborhoods are more likely to keep up with inflation over time, or in my case exceed inflation. So, I always had the preference of ending up with a portfolio of fewer, higher quality, lower headache, free-and-clear properties even though they cost more as opposed to a portfolio of cheaper, lower quality, more management intensive, properties that were highly leveraged. Whatever it is you want in the end, figure that out first and then reverse engineer your plan to get there from the end state backwards to the present ... then execute that plan into the future, making adjustments as you go.

This is how I have managed it and why, though my view is a bit different than most. I can say that this has worked for me, though.