Investment in rental property: Should you leverage if you have ability to 100% equity finance?
Got asked for advice/to help find rental properties by a close acquaintance. As I have 0 experience in doing any RE deals, I was wondering if someone could help me out by giving some helpful pointers on what to watch out for. The said person originally wanted to pay 100% cash for several properties in the 600-900k range, originally I thought this would be a 'bad' idea? I figured as debt is currently moderately cheap it would be beneficial to take mortgages on the properties to be able to invest in more opportunities and spread risks across more assets. Moreover, I thought about setting up a legal entity which would allow for a tax deduction as a result of the interest on the debt.
Any advice, pointers towards useful resources or personal experience to figure out the most important pros and cons would be greatly appreciated.
Just some broad advice, keep in mind that in life very rarely are things black and white - similarly, leverage isn’t necessarily bad or good but depends upon the context for which it’s used.
As you mentioned above, the big advantage of using leverage is that by borrowing money you use less of your own capital. The “juice” is that you can do the same size deal using less of your own money while receiving theoretically the same profits you would if you didn’t. You get a higher return on your money because you are using less of your own.
The bigger reason why most operators borrow aggressively is not to inflate returns however - it is because most developer/operator/sponsors do not have much of their own money so they need to borrow to stretch their own capital to do more deals. Say I have $100 as an operator to use for projects, if that project costs $100 then I can only do one deal but if I borrow 65% of the money (relatively modest leverage) then I can 2.85 projects of the same value deals. Operators also often get paid acquisition (% of purchase price) and asset management fees (% of total project cost and/or net operating income) which are huge to sustaining/paying their back offices and staff.
Now back to your original question as to whether or not you should use 100% equity - it depends on the operator and the investor’s goals. Is your friend (the operator) looking to expand the business and do as many deals as possible? How much debt or could they even get debt with their own individual balance sheets? As far as the investors go, do they want to place their capital long term or turn it quickly? What kind of cash on cash returns are they expecting? One thing to keep in mind is that we are in a very unusual interest rate environment so we are seeing some investors (typically institutional) who would rather buy all cash and get paid the 6-8% return on their own money vs. invest elsewhere.
The simplistic answer is that your instincts are correct and in most instances you would want to take advantage of these insanely low rates and put on conservative debt of 50-65% LTV with interest only, low term fixed rates.