Often I visit a great real estate social network called Bigger Pockets. Recently a new member at the site, Daniel, outlined his investment strategy that was focused on buying properties cash, re-investing all cash and salary and building a portfolio slowly and safely. See the thread here.
I am not going to knock his strategy, but I wanted to sit down and run the actual numbers to see what the actual difference in return is.
For our hypothetical situations we will compare three scenarios:
Assumptions we are going to make in all scenarios:
I decided to run three real rental properties I purchased in 2009.
The results are more or less what I expected. Clearly the more financing you get the higher your ROI is but for the benefits of financing to pay off your ALL CASH yearly ROI needs to be less than your cost of funds. So if you are borrowing money at 12% instead of 8% on Prop A and you finance it to 80% you will be breaking-even and it is really a lot worse than that because you have 20% of your money invested in the deal, earning $0 return and your managing a property for free.
Now for the fun part of the project, let’s make some wild assumptions and assume 10 years from the purchase the property will return to the previous 2006 peak value. I have no idea if the market will ever get there again and as long as I am cash-flowing I don’t really care if it ever gets there. But what does it hurt to run the numbers.
The assumptions I made for this are:
Again, I am not saying I think this is what is going to happen.
Essentially this really shows where the power of leverage can really spice things up.
And for my last point, leverage can go both ways. If rents drop significantly, major disasters or any number of events happen your losses will grow to a level that might be unbearable if you use too much leverage. I read the book on the founder of In-N-Out and he bought almost all of his restaurants cash and in the beginning he rarely used borrowed money to grow.
I don’t think anything is wrong with owning properties free and clear (in fact it is part of my long-term strategy), but when properties can be purchased at these prices leverage can really be a great tool for investors to take full advantage of the market.