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.
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Debt amplifies gains and losses, so if things go well, it juices your returns, but if things go south, it'll wipe out your equity.
Still a student so please don’t take my advice but I’ve always understood that debt tends to juice returns and allow you to spread risk. Basically what you mentioned. Happy to hear others thoughts.
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.
Very helpful response. +1 SB.
Also worth noting that rates seem like they'll probably be low for a while. It may be worth it for your friend to buy all cash and re-evaluate his leverage strategy in a year or two. Buying investment properties can entail all sorts of costs and risks that aren't immediately apparent, and having cash flow unconstrained by debt service gives a lot of room to maneuver. Maybe you end up contracting out a lot of maintenance or back office work at first, that later can be dealt with "in house" more cheaply. Maybe some unexpected deferred maintenance crops up, that suddenly can be paid with out of cash flow instead of finding more capital. Shit like that always occurs, there is always something unexpected.
And in 18 months, when your friend has a handle on the operations side and has identified a couple new potential opportunities, then you take money out. Also allows you to more accurately calibrate the amount of leverage needed.
Great answer. Really well written and clear
Both above answers were great and well thought out. Oz is absolutely correct.
That said. Leverage the building, immediately. Assuming it is a cash positive leverage. Your interest expense will help your NCF after tax. I wouldn't leverage 80% LTV either, I'd be in the 50-65% range, don't do I/O and maybe look and see what the rate difference is if you can get a 20 year/25 year self liquidating loan. You will have cash that you can come out of pocket with if an unexpected event happens. Also, start a property management company. You will be able to get a line of credit to help cover the cost of whatever repair comes up. So you don't have to make a capital call to yourself.
Oh, I'm not saying leverage to buy more, still acquire that 900k building, just use 50% debt. I'd be super conservative right now.
If it's a low amount of leverage (and I'd even say 50% is on the high end) then sure. But if you're going to just sit on that cash and juice your yield, then it may not make sense to take a low leverage loan. You're still on the hook for those financing fees, and you almost certainly aren't gaining anything on arbitrage on the mortgage if it's just sitting around in a fixed income security or in the market.
The whole key to succeeding in real estate is not going bust. Everyone has bad deals, everyone gets hard knocks, it's just the ability to hold onto the propert(ies) for the long term that separates the winners from the losers in this business. Were I the OP or their friend, I would be as conservative as possible. When you're at a fund, juicing the last 50 bps out of a deal can be huge when it comes time to sort out the waterfall - when you're starting to acquire rental properties that will be amassed into a more substantial portfolio 10-15 years down the road, there is no need to take more debt than necessary or to incur costs beyond what you have to. I agree that the debt market is so attractive right now that it almost seems insane not to leverage anything and everything, but again I want to stress that what makes sense for a guy who owns a couple duplexes is not the same as the landlord with a couple thousand units.
Also, as a case study, look at what's happening to Airbnb owners the last six months. They're essentially doing the same thing (buying small rental properties), and now they're getting slammed and probably losing the keys. It's easy to say that COVID-19 is a once in a lifetime event - but then, we're only 10 years out from the last "generational" problem. Shit always hits the fan eventually. Being in a position to weather a downturn and come out the other side with a little bit of cash to your name and a positive relationship with lenders as a solid bet is the way to make huge money in this industry.
Yeah. agree. However, we are in a strange time where past paradigms pose a different risk. There is a point in the amort where you can get the full after tax benefit without juicing or levering yourself. You may be able to buy several of these with very low LTV and receive the same tax benfits, and use interest, and hedge against 10 year balloon. A self 15 year self liquidating loan, allows you to leverage yourself conservatively, and if you decrease the dscr constrained loan even further you can get what approximates to a same size payment(yield), while receiving the same after tax income(since interest is expensed). You also pay 63% of your loan back in year 10, while a similar rate for a 30 year am will have you paying back around 22% in year 10. I would use amortization as a hedging strategy right now. While I see inflation "bound" to occur, my crystal ball says a high likely hood of higher interest rates and lower asset values is what a real estate owner should be concerned about.
Hi all, just wanted to thank everyone for giving some interesting pointers. We have ended up acquiring a few properties with very conservative leverage (and also lower values) in some interesting areas with high demand for smaller starter properties and little to no new developments. Key reasons being: Limited experience, and hence better to start small and work our way up and also being able to spread some of the risks across multiple assets. With COVID and the WFH situation, we have had no problems regarding the vacancy rates and were able to get above-market rates.
Thanks again, as some of your comments were definitely taken into account in some discussions - did not expect this much input from a forum!
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