Using Leverage vs. Paying Cash for Properties

Many investors have the turtle mentality: they’d rather pay cash for their homes, and when things get rough, they tuck themselves back in their shells. That might seem like a great plan, but it can cost you some big earnings in the long run.

The Scenario

Let’s look at a real-world example. Say you found a good B+ property for about 100k. If paid all cash, your $100,000 would earn monthly cash flow of about $665/mo. after all expenses. You have to save your cash flow for quite a while before you can get another property. With 665/mo. you’re looking at another property in 12 years.

Now, imagine using leverage to buy four properties with that same $100,000 instead of just the one. After debt service, you make only make $260/mo., but that’s on each home, which means you earn a total of $1,040/mo. in cash flow. A pretty big difference, eh?

Pros and Cons

Still, this strategy, like all others, has distinct advantages and disadvantages. Leverage provides you with better tax write-offs. You’ll also get all the cash flow, principal paydown, and appreciated money from the banks. Your portfolio will grow exponentially too because you start with four homes instead of one.

Of course, you need a cash reserve in case of emergencies. You should save your first few months of cash flow to cover the mortgage, just to be safe. And you’ll obviously be in debt, so leverage comes with natural risks.

How to Mitigate Risks

In almost every situation, you’ll be smarter when you use leverage rather than pure cash, but you have to do it right.

First you have to learn to be an investor instead of a speculator. A speculator buys a property and thinks, “If this goes up, I’m going to make lots of money! I hope that happens!” An investor says, “I’ve looked at the market conditions and trends, and I know I’m timing this right.”

Knowledge and risk don’t often coincide. In fact, you risk more by refusing to act rather than investing and falling victim to the worst-case scenario. You’re more likely to succeed when you take the time to educate yourself. Learn to buy in the right market at the right time. Save the cash flow, and then in as few as five years, you’ll have all your initial investment back.

As a leverage investor you’ll want to be aware of your Debt Coverage Ratio or DCR. If the DCR of a property is at a 1.0, you’re receiving enough income from the property to just barely cover the mortgage payment. If it’s at a 2.0, you can feasibly pay for your property’s mortgage twice over. Most banks look for a DCR anywhere between a 1.1 to 1.2.

Know the Terms

Cap rate (also called Net ROI): Helps you determine the value of your commercial asset with cash. If, for example, you have a cap rate of 10% on a 100k purchase, you’re making 10% of your investment annually.

Cash-on-cash return: Helps you measure the actual profits you receive on the down payment if you are using leverage. Say you make $265 in cash flow per month. Multiply that by 12, and it equals $3.180. Now divide that by your down payment, perhaps 25k. Your percentage rounds up to 13%, which is higher than your cap rate.