What does it mean to leverage while accounting for cash flow?

Question

Hi there. I am new to this forum and relatively new to real estate investing. I have one rental and two more currently under contract. All are single family homes that I am planning to hold and rent for the foreseeable future, with no current plans to sell (though will reconsider in 5 years). The first home I bought with cash, but refinanced to get 75% back shortly after closing in order to free up funds for additional down payments. All are currently on a 15 year mortgage, rates at ~3.75%, with a purchase price of ~165k and renting out for ~1400/mo. After the mortgage, insurance, taxes, and HOA, we are left with no cash flow at all. Yet, all the advice I've seen is to make sure the month to month cash flow is high, several hundred $'s in the positive each month. We are clearly not getting that.

So my question is, when people say "leverage," the more they leverage the lower the cash flow, right? What is a good balance? Regarding the term, I chose 15 years over 30 to lower the interest rate and to pay less over the life of the loan, though 30 years at 4.25% may leave us with $250 in the positive per month. What's better? A few hundred/month now or tens of thousands saved later?

John Horner · Answer

It depends on what your goals are. If you want to grow fast you need to leverage more, if you want to be more passive and grow slower you can leverage less. Mine are usually leveraged around 60%-70%, this gives me the peace of mind that if the market dips aren't underwater, but doesn't leave a ton of cash in the property and still provides solid cash flow.

John Whittle · Answer

Leverage would be taking advantage of the cash you have. Using the smallest amount of money down or sometimes no money down. So you can keep cash for more deals. Buying 4 rentals 25% down each with 160k cash instead of buying one all cash for 160k, is using leverage. You increase the income with 4 rentals over one even though you have to pay for the mortgages. Going from a 15 year loan to a 30 year loan would be another way to use leverage.To take advantage of leverage you still have to produce cashflow. Your actually negative cashflow if your not accounting for maintenance, vacancy, evictions and capitol expenditures. Even on a 30 year after you account for all the hidden costs you are still in the red. Basic numbers are 10% for maintenance and 10% for vacancy of gross rent. I hate to say it but you really need some properties with better numbers. I've seen plenty of landlords with one or two properties cruise by for years with no issues, barely making a dime waiting for it to be paid for. Then a bad eviction comes, rent doesn't come for months, the tenant destroys the place, the furnace goes out, it all hits once and really hurts.

Ralph R. · Answer

Jane Du Jane another thing to remember is equity in the house is like putting money under the mattress. You can't spend it, it doesn't make you any money and the longer it's there the less buying power it has. Cash flow is another deceiving thing. If you put $20,000 down payment on a property you are really getting your own money back at a very small rate (cash flow). With that in mind the renter is keeping the house afloat and if the market goes up your gain comes from selling (and paying taxes) or from refinancing (no tax ) and reinvesting in more property. This cash out refinancing will get your down payment back with any luck, the principle the renter has paid, and any appreciation. More money for another property. I view the renters as holding the property for me till I can get my investment back. Then it's closer to true cash flow. One other tip. Get shed of those 15 yr notes. I had 2 of them. Finally got rid of the last one. If you want equity get a 30 year loan and pay extra principal payments. Then when a tenant moves out you can make the lower 30 yr payment easier. Re fi's are expensive so I waited until I had a few years in them to justify the cost. Then the market went up a little so I took some equity too. The last year on one I had some heavy maintenance and I lost 3000 dollars. The 3k came out of pocket. Should have just got the re-fi right away. The average investor re-finances every 7 years. The tenant is paying the loan and interest. Your not saving any thing by using 15 year notes. At some point you will sell or do a 1031 exchange into a bigger investment. The idea isn't to own the house. It's to make money from it. The saying goes cash flow pays the bills. Appreciation and value add grows wealth. Appreciation is more risk tho because not all houses go up in value. Some you buy needing a re-hab and can make money fixing then renting. You have to decide your goals and risk tolerance and go from there. As you get closer to retirement you probably won't care whose money your getting so you will likely want high equity, high cash flow properties. RR

Bart H. · Answer

@Jane Du I think part of the discussion is what are your goals? If you were a doctor with a high income, maybe you'd want to deploy capital that has little to no return now in exchange for high clash flow in 15 years (ie when they with to retire). Maybe you are a young investor trying to get as many properties with as much cash flow in hand with a minimum amount of available capital. In that case you would want non amortizing loans, or 30 yr notes that allow you to get as much leverage (debt) as possible.From a finance theory perspective, debt is 'cheaper' than capital. So finance theory would tell you to control as many properties as possible with as little capital as possible.If you were older and on a fixed income, maybe the cash flow from paid off properties would be most important. The 'risk' would be the lowest, but the return would also be theoretically lower.Beyond cash flow, maybe your focus is on capital appreciation, or maybe you want to minimize risk, or focus on capital return, or risk adjusted return.You are discussing a 15 year note. Think at first about your returns without leverage, ie without a loan. If a deal makes sense without a loan, THEN consider the financing. IF you think about it, a property paid for with 100% cash will have the highest cash flow. On the other side a house with 100% debt will show the highest return on investment. (ROI). There is no absolute right or wrong. But know that identifying your goals ahead of time will go a long way to identifying how you personally want to invest.

Jane Du · Answer

Thanks for the feedback, everyone. I'm going to have to look up some of these acronyms. It sounds like the consensus is we should find better purchase price to rent ratios. Those are difficult to find around Dallas right now and these numbers are about the going rate. I'll add that these are all newer builds with minimal, if any, repair work before they can be rented out. One first one we didn't even vacuum or wipe down the counters, it was in such good condition. Let me also add that we don't require the cash flow right now, although it sure would be nice. And our goal is to overall maximize total return over the long term. Basically a retirement plan. Does that change anything about your advice? And I would love to hear what it is that you do. How much are the properties? How many % down, 15 or 30 year term?

Jeff B. · Answer

There's a metric to measure this: Cash-on-Cash (CoC).compare the NOI to the down payment.Leverage is a term applied to the purchase. After closing, we think of ROI and that's where you're drowning.However, using OPM, we opt for a long term loan to reduce mortgage payments and your choice went the other way and thus drained your NOI.

Joshua D. · Answer

@Jane Du "What's better? A few hundred/month now or tens of thousands saved later?"Great Question! problem with this one is that there is NO 1 right answer. You are breaking even at best right now with the cashflow and if any repairs come up you lose money. To say this is a WRONG investment plan is short sighted at best. If you are making 200k a year and are able to save 5k a month to invest, and you don't care about current cash-flow. this could be fine for you, this sucker will cash-flow great in 15 years. And in Dallas I imagine you will have some good appreciation during that time. If however you are like me and make 35k a year and have 2 kids... I would NEVER buy a cash-flow negative deal. We look for $200-$300 a month cash-flow on our rentals that rent for 700-800 a month. keeps me safe from having to pay for anything outa pocket. Just too risky for us.