Free & Clear Properties or Leverage with Cash Flow?

Question

What would you suggest? If you had 150,000 free to invest in rental/buy and hold properties. You could purchase perhaps 1 or 2 houses free and clear with money.

or

You could take that same amount and leverage them with a loan over 5 properties and cash flow a bit. What would you suggest?

I am facing a situation similar to this, the only issue I have with leverage is the possibility of becoming overleveraged from too many loans.

Don Konipol · Answer

I think the answer to the question of why high leverage when young and low leverage when older is time.  If you are wiped out in your twenties, you have a lifetime to make up for it and more.  With fewer, or much fewer working years left, your ability to make up a loss is greatly decreased.

Jon Klaus · Answer

One of the advantages real estate offers over other investments is the ability to leverage to a large degree.  This offers cash on cash returns that can double or triple other options.

Every investor needs to look hard at this and come up with their own thresholds, tolerance for risk, and contingency plans.  In Don's case he seriously leveraged when he was younger. But gradually deleveraged as he built net worth.  I agree with this plan. It also tends to correspond with age. Here's an example chart:

Age   Leverage
20's    80%+
30's    80%
40's    70%
50's    60%
60's    50%
70's    Work towards free and clear

This is just an example, but its good to have a plan and philosophy behind it.

Jad Allen · Answer

There are pros and cons with both approaches.   In high price areas such as LA, NJ, or Washington leverage has to be used.  In the south and Midwest this is not the case.

Something to always to think about.  Probably 90% of people who fail in owning real estate are overleveraged and lack cash.  Might be closer to 95%.

Leverage is the fastest path to wealth, but it is also the fastest path to bankruptcy!!

Moderation and patience are greatly undervalued in business.

Doug French · Answer

I think it all comes down to personal preference. One can argue either way. If you loose sleep at night worrying about how you are going to pay the mortgage all cash is the way to go. Personally, I have about 40% equity in all my deals. I do 15 year fixed notes typically. My goal is to eventually have ten free and clear and from the CF they produce by one additional SFH a year. My primary business is very risky so I am trying to balance that with free and clear SFH.

I was always taught leverage magnifies everything. If things are bad leverage makes them worse, but if things are going good (appreciation) leverage is great.

Oliver Trojahn · Answer

Jon Klaus showed a perfect example of leverage through the ages.  I am 27 with a full time job.  I own three SFR rentals that were purchased with 20% down using conventional financing.  If I had 150k cash I wouldn't think twice and buy 5 financed rentals using conventional financing with only 20% down.  However, qualifying would be tough for all of those at one time (so I would probably buy one every six months or so).  Real estate is a leverage game but you have to be smart and buy great deals that this forum has taught me.  Theoretically, the deals you purchase should cash flow great while leveraged at even at 80%.

My particular plan has me switching to commercial in my mid 30's-40's, however, I will still be using leverage as I am very comfortable with it.

Great topic

Seth Williams · Answer

This is a great question Samantha. There are definitely pros and cons with each approach, but I think it ultimately boils down to a person's philosophy on debt and how much is tolerable.

In the commercial banking world, the rule of thumb is that a person's debt to income ratio (how many dollars of debt they pay vs. how many dollars of income they make) shouldn't ever exceed 40%. My own personal philosophy is that it shouldn't exceed 25% (which is a pretty conservative approach).

And keep in mind, just because you buy a property doesn't guarantee that it will cash flow immediately (or ever, for that matter).

Whenever I buy a new rental, I usually don't make any money on it for the first 3 - 4 months (because we have to evict old tenants, make repairs, bring things up to code, etc.). With this in mind, if you are going to borrow, it would be wise to go slow. Buy your properties over the course of a year or two - make sure they are actually producing as planned before jumping into the next deal.

Don Konipol · Answer

When I started investing 33 years ago I  leveraged to the hilt - didn't have much to lose.  Now I purchase cash no debt.  Thinking of taking on some non recourse debt though.

Dawn Anastasi · Answer

Buy 1 or 2 houses free and clear with $150,000?  No way -- I would buy 4 properties cash only, which include the costs to fix them up, and still have money left over!  (But that's the market I'm in.)

Jeff S. · Answer

Samantha M. like people are saying age determines the amount of risk but some young people aren't risk takers and some older ones are.

If you are older you should have some assets so leveraging the 150k shouldn't be a problem because you probably have more than that in accessible liquid assets.

When you are young time is on your side so leveraging is important and while you are probably using almost all of your available assets, if everything falls apart you have time to recover. Many successful people have lost and rebuilt. Some think the best investors are those that have lost it all and started over much smarter.

Tiger M. · Answer

It's not that simple with limited information about your current financial situation, age and goals. You never should get too close to your own personal debt thresholds. At the same time, if the market is at 2004 levels in your area, then you want as much leverage as possible. You have to find your own balance. There are many leveraging, many paying all cash. If your currently well balanced, then why not pay cash for one and leverage 2. Then if you need cash, cash out refi, then funds sit in your war chest to be deployed if required, but cash flowing stability in your portfolio in the mean time.

Free & Clear Properties or Leverage with Cash Flow?

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