Is financial leverage good or bad for real estate investors? Is there such a thing as finding balance?
This is an incredible time for investing in cash flow producing real estate. Yet, even though interest rates are still very low, and asset prices are attractive, and we have better access to data for predicting the future than ever, many are struggling with the leverage question. Some have burned themselves and are trying to avoid borrowing even a penny, at all costs. Others are fresh to the market, and have already long forgotten the mistakes of their parents and the dangers of leverage. So which camp is right? Should real estate investors avoid leverage like the plague and refuse to use loans? Or is using leverage critical to financial success?
The New Cash Flow Investing Landscape
Cash flow real estate investing exploded after the downturn of the early 2000s. While wholesaling and flipping houses is still the preferred real estate investment strategy of many, more now seem to appreciate the value and importance of investing for passive income, and especially with real estate as collateral. Massive swathes of American real estate have been converted into rental housing, and more is on its way there. While there are still some very cheap properties coming on the market, the recovery has also pulled property prices up substantially. With one expert speaking out in belief that the U.S. economy will soon double via the CCIM Institute, and historical data suggesting that American property prices have room for 100% growth before settling in again, it seems hard to lose on well-chosen income property investments.
There are two camps of individual investors wading into this investment landscape. The first are those that have become paranoid about taking out loans, being burdened with debt, or dealing with banks. Some have the financial capacity to purchase properties with cash, or draw down from retirement accounts to do so. This can put real estate investors in a strong position when bidding on, negotiating, and operating rental properties. That is, however, until they run out of cash. Others rightly point out that it is very difficult to gain any meaningful traction this way. It means a lack of scale and real liquidity. That can be even riskier than having some leverage in place.
The second group mostly consists of newer real estate investors. They have no fear of leverage. It’s all about cash flow. For some, it even appears acceptable to invest in negative cash flow properties and leverage more than properties may really be worth.
Good Versus Bad Leverage
We are often taught that there is a substantial difference between good and bad leverage. Just like money isn’t good or bad itself, but what people use it for, or how they treat it can be. Not all will agree, but there is a substantial difference between short term borrowing with very realistic expectations of paying it off, and maxing out credit cards or using credit to buy something which is really just another liability. Cars are a great example of this. You may live in an area where you can’t get to a job or earn unless you have a car. Your only option for buying a car and gaining that income may be to get a loan. Now you can buy a reliable, modest car and pay it off in three years. Or you can max out your financing and buy an exotic, high maintenance car that will cost you thousands each month to maintain. A car that might eventually cost more than you earn, and may take seven years to pay off, if you can even hold onto it that long.
The Myth of Being Debt Free
Truth be told, it is virtually impossible to live debt free today. If you own a property, you’ll always have maintenance, insurance, and property taxes. Even if you stay a renter, you’ll have income taxes, and health insurance, and healthcare. Not to mention food needs and rent. You’ll always have financial needs. So the question becomes how can you stay ahead of those needs and financial outgoings by increasing your income. Investing is the obvious answer. Sometimes using leverage to invest is virtually inevitable.
In order to grow investments, you need financial leverage. This can actually help reduce risks. By using financial leverage, individuals can lower their personal risk and diversify.
Beyond the Bank Loan
Not wanting to deal with old banks that have proven to be malicious, or taking out mortgages is understandable. Fortunately, there are other options:
These can all help with growth, and in retaining flexibility. It is possible to find balance in using leverage, and to use leverage wisely. So what will you do?