The housing crash entirely restructured the American mortgage market. Part of that development has included tighter restrictions on obtaining mortgages, coupled with an abundance of newly available homes for sale. This, in turn, has allowed some investors to buy second properties for investment and rental purposes.
There are two major schools of thought when considering real estate investments and how to approach them: One believes it is wiser to pay all out cash for a second home, while the other side holds that being leveraged on a second – or even third or fourth property – is far more lucrative. Here are the cases for both.
The Case for Leveraging
This debate is heavily covered online, and several financial news sites and blogs state that being leveraged makes more sense when buying investment properties. For example, Ali Boone of BiggerPockets.com argues that the returns are higher and the risks are lower when leveraging this type of investment. The logic behind this is that if property increases in value, an investor will have put less down, but can then receive far more than his original capital.
For example, let’s supposed you put down 15% on a $500,000 house. Your initial investment would then be $75,000. Two years later, should that house increase in value to $650,000 you could sell and receive far more than your initial $75,000. In this scenario, your principal investment of $75,000 gets returned, plus an extra $75,000. In that case, you would have risked far less than a cash-buying investor would have in this situation, yet still made a considerable profit.
Multiply this formula and strategy over three or four properties, and the savvy investor can turn quite a profit. A leveraged investor has more opportunity than his cash-buying counterpart in these types of situations. Cash buyers will often buy a house outright with most of the money they have available for an investment. In contrast, a leveraged investor can diversify the allocation of that money across several different properties, thus possibly increasing his rate of return in the long run.
The Risks of Being Leveraged
Taking on any type of investment has an inherent risk – especially when dealing with uncertainties in the housing market. First and foremost, the diversification of money across investment properties is an approach that should seriously be considered only by a well-informed investor. A sharp understanding of current economic conditions, the overall health of the housing market in general and the area into which you are buying specifically is necessary.
While there are several advantages to taking out a loan to buy an investment property, things could go awry. Let’s assume each rental property depreciated sharply in value. The leveraged investor now owes far more than he or she ever put down. Should you misstep the market by even a little, you could lose massively, especially with a couple of properties in your portfolio. While a benefit here is that the bank will certainly lose more than you will, your credit score could be severely impacted. The potential for significant returns attracts many to this type of strategy, but it should be approached with clear consideration for all the risks involved. This strategy will, of course, also require you to go through the mortgage process – in many cases, several times – which is another thing to consider.
The Case for Buying Proprieties in Cash
Cash investors can sidestep the entire mortgage application process and make a quick investment should they see an opportunity, which is highly advantageous. Another benefit to paying cash for a property upfront is that you don't have to pay interest. Even with interest rates as low as they are now, it will always be more expensive over the long run to pay any type of interest than it will be not to have any.
For many investors who have the funds, buying property with cash makes sense, especially if you believe the market will upswing greatly in the next couple of years. For example, let's say you buy a home outright for $400,000 and sit on it until you see the moment is right to sell. Should you be right about an upswing, and the home appreciates in value to $500,000, that’s a direct profit of $100,000 to the investor, without having to consider paying the bank interest payments or the amount you borrowed in a mortgage. Having 100% equity in a home also makes it easier for an investor to take out a loan against it in the future, should that be needed. Buying a home outright in cash can also create immediate cash flow for the investor. Certain investors look to create moving income with their properties, and the right type of renters can provide this.
The Risks of Paying Cash for Real Estate
Tying up all of your assets in one investment is extremely risky. Therefore, this approach might not be the best strategy for the investor who has a limited amount of money to use in the long-term.
While a home can increase in value, it can just as quickly depreciate, and the money you lose will be outright. Diversification is one of the fundamental commandments of investing. Tying up the majority of assets in one asset class can provide massive loss. Putting hundred of thousands of dollars into one asset class also ties up your liquidity until you have a seller.
The Bottom Line
Both strategies offer advantages, but for different types of investors. One important thing to note is that either strategy requires a substantial amount of disposable investment income. Even leveraged buyers who spread out their investment across several properties will need to assume the risk that all of those properties depreciate. Further, when purchasing a new home for cash, do not use retirement savings or your emergency fund.
For the investor who has a large amount of money ready to invest, propensity for risk is what will truly drive the direction of the decision here. Leveraged positions in investment properties will undoubtedly yield higher returns, but for the less-involved or dovish investor who still seeks equity and return, cash purchase might be the better option.