Rentals: Debt and Leverage, Free-and-Clear, or Happy Medium

[Alain Perez-Majul]

Hey guys! Surely this has been discussed before, but figured I'd start my own thread on this topic for convenience's sake (selfish, I know haha). 

Although my active real estate business is wholesaling, my goal is to channel the opportunities and income from wholesaling into a buy-and-hold approach, as I'm sure many others who find themselves in a similar situation do. While I've accumulated a decent amount of experience on the rental side over the last few years, as time goes on I continue to learn more about real estate financing, taxes, and my own sanity (lol), and as a result, my perspective and opinion on debt and how I personally approach it changes.

Undoubtedly, there are many pros to leveraging debt when investing. One can scale a lot quicker. One can take advantages of tax write-offs. It allows you to employ BRRRR (if done correctly). However, leveraging can also bring about its negatives. Your cash flow per unit is significantly affected. When scaling quickly, you have more properties to worry about and more potential headaches. It also makes you more vulnerable and susceptible to economic swings. Overall, it can add a lot more stress to your life, and while scaling and owning a ton of real estate sounds (is?) sexy, if it's detracting from your quality of life, one could argue it defeats the purpose; I personally know investors that went from owning 60+ SFR's with debt to selling most doors in order to own a fraction of them free-and-clear for the peace of mind and ability to "sleep better at night."

Of course, there is no one way to skin the cat, as different investors have different risk tolerance, and different approaches to this business in general given a wide array of varying factors. And so I'm curious:

As a buy-and-hold investor, where do you stand and why? Do you prefer to leverage as much as possible, or would you rather own free-and-clear? Have you found a happy medium with a mixture of both? Perhaps you throw debt on some, and not on others, or maybe you leverage each at 50%, or any other ratio that is not a typical 75% LTV (of course, this depends a lot on the lender), in order to cover more risk and utilize the advantages of leverage while safekeeping sanity. Regardless of approach, how did you arrive at your chosen relationship with debt (or lack-thereof) and what major points did you consider when arriving there?

There is no right or wrong way to this, and investors figure out what is personally "right" for them. I myself am still on the journey figuring out my ideal balance- which is why it'd be great hear how people approach this relationship in their personal investments. 

Would love to hear your thoughts!

Cheers

[Joe Villeneuve]

It's a question of basic math.  Everything that comes out of your pocket is a cost to you (as in paid for by you).  Everything that is paid for out of the rent is a cost to the tenant (as in paid for by the tenant).  In order to make a profit, you have to recover "your" costs.  The larger "your" costs are, the more "you" have to recover and the longer it takes.  The larger the DP, the more "you" paid for the property since the rest of it, if leveraged, is paid for by the tenant...as long as you have positive CF.

Example:  $100k property; Cash Flow without Mortgage = $10k/year;  CF w/ mortgage = $5k/yr

Option #1 - 100% cash purchase of 1 property
Cost = $100k; 
Equity  = $100k
CF/Yr = $10k
# yrs to recovery of cost = 10
Profit after 10 years = 0

Option #2a - 20% DP; financed = $80k of 1 property
Cost = $20k
Equity = $20k
CF/Yr = $5k
# yrs to recovery of cost = 4
Profit after 10 years = $30k

Both properties appreciate the same based on $100k in property value

Option #2b - 20% DP; financed = $80k times 5 properties (using the same $100k)
Cost = $20k/property = $100k
Equity = $20k/property = $100k
CF/Yr = $5k/property = $25k (5 propertis)
# yrs to recovery of cost = 4...all 5 are recovering simultaneously 
Profit after 10 years = $150k

All 5 properties appreciate the same, but the total appreciation is now based on $500k in property value, meaning you would be gaining appreciation 5 times faster than the first 2 Options.