If you have money on hand, paying cash for your next real estate investment versus leveraging your portfolio can be seen as a less arduous process and may initially cost less since there are no financing points or interest charges. However, does that really mean it is a better strategy for you? One must compare the financial risks versus the returns for both scenarios. Let’s examine the following scenario:
Assume you have an investment property opportunity for $100,000 and you are contemplating whether to pay cash or finance the transaction. Your plan is to update the property, add some value to it, and then sell at a premium. If your projected return on investment is 20%, that means that you are in this project to make $20,000 in 4 months. If you decide to pay all cash, you will be putting all your eggs (cash) in one basket as you will have less money to invest in other properties or pay for renovations. If anything was to go wrong with this project, you may stand to lose a sizable portion of your original investment.
If you decide to finance at 80%, you will invest 20% which means you will have $20,000 invested in this project, and $80,000 more to invest in other opportunities! For the sake of this argument, let’s assume that you will use the remaining $80,000 to finance four more projects at the same cost structure. At this point, you would be multiplying all your returns by five, and you would have diversified your investment over five different projects rather than just one, which means you have five times the opportunity of earning the 20% return and if all projects unfold as planned, you may earn five times the 20% expected rate of return.
After analyzing cash flows and deducting all the financing charges, you will discover that you are still at an advantage since you now have five projects with expected positive returns, not just one. Also if one project has an issue, you still have four other properties to count on.
From a risk stand point, and as far as the collateral is concerned, financing is less risky than paying all cash. If for any reason in the above example the property depreciates in value and you are not able to liquidate it at a profit, you may lose up to 100% of the initial $20,000 invested rather than losing the entire $100,000 if you had paid all in cash. Also, financing puts more risk on the lender than you since usually the lending institution picks up the higher loan to value portion of the deal.
Finally, with leveraging, you would gain essential investor experience in working with a financial lender and developing added expertise as it will take more work and skills to manage multiple projects at once. While working with a lending institution might be time consuming, the reward will definitely be worth it since you will be multiple steps closer towards becoming an entrepreneur and building your own real estate empire.
CoreVest is a leading provider of financing solutions to residential real estate investors. We provide attractive long-term debt products for stabilized rental portfolios as well as credit lines for new acquisitions. For more information about how CoreVest can help grow your rental and rehab business, please call 844.223.2231 or submit our contact form.