Surprising Investors With Sound Advice on Leverage

by Chris Clothier, co-owner of MemphisInvest.com

eal estate investors are being bombarded with advice today from every direction and it is sometimes hard to nd two pieces of advice that are the same. There are so many options and so many opportunities that becoming confused is a common feeling among investors. Well get ready, because here comes one more piece of advice that may run contrary to what many are advising investors to do today. I happen to have learned my lesson when it comes to leverage and I have a special place for it in my portfolio. Smart real estate investors are learning to use leverage wisely and efciently to put more money in their pockets. SURPRISING INVESTORS WITH SOUND ADVICE In the 4th Quarter of 2012, I made a presentation to a group of investors in Northern California and I surprised many in the room when I made a statement that I did not believe you should buy real estate and leverage it for cash ow. Given that I am a partner in two companies that specialize in helping investors nd properties that provide a positive cash ow after leverage, this statement caught much of the audience by surprise. But I followed that sentence with a bit of a clarication. I told the group that there are many ways investors can be fooled or even fool themselves today into thinking that they are making a positive cash ow on their property. I told the group that often, the biggest mistakes investors make, is sacricing long-term stability for short-term gains. THE BANK WINS EVERY TIME When I purchased my rst home, I was given one option by the three different nance companies I visited a 30-year

Smart real estate investors wisely and eciently to put

are learning to use leverage

more money in their pockets.

mortgage. The 30-year mortgage has become the staple of real estate investing and even Warren Buffets recent statement about the 30-year mortgage shook the real estate world. What many people fail to recall about Warren Buffets assessment of investing in real estate is that he used the phrase if he could which, is very different than stating this is what I am doing. This is worthy of an article all by itself as different investors and investment companies have taken his short interview and turned into the greatest marketing piece they have ever had. His ve minute interview has been used thousands of times already to convince investors that they need to mortgage to the hilt all because Warren Buffet mentioned it in his interview. But they all forget two important points. 1. He is one of the wealthiest men on the earth and can afford as much leverage as he is comfortable taking on. 2. He never says that he is buying single-family homes.
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He actually lists reasons not to. Now, the mortgage is not one of his reasons, but why would it be? Like I said...he is one of the wealthiest men on earth! The point is that a 30-year mortgage has become standard and not only standard for what companies want to show, it has become standard for what investors want to see. How Do Investment Companies Show their Numbers? Many companies, who provide investment opportunities, including mine, will show a mortgage projection based on the 30-year mortgage. Why? Because it is what the average, every day investor wants to see. It is how we have been programed. A simple search of the Internet will return article after article extolling the benefits on using a 30-year mortgage, especially for the positive effects it has on an investors cash flow. When I first started investing, I was coached to use the 30-year mortgage as a tool to boost my monthly income while allowing a renter to pay down my note. When I first started, I loved the idea of using a 30-year mortgage and putting 20% or less down as a GREAT tool to boost my cash flow. And it did. It made my cash flow go up and I had a certain level of comfort with that. The problem is, unless you have significant reserves in place, heavy leverage can

be paying more in interest payments than I was earning in cash flow. In the first 15 years it would be substantially more! Own Property Outright And Reap The Rewards I am a big proponent of owning real estate outright. I have used leverage sparingly over the last four years and only as a tool to acquire properties and not as a tool to own properties. I have put every property that I have used leverage to purchase on a quick pay off schedule. Many homeowners and real estate investors will tell you that there is a simple strategy that makes a 30-year mortgage a good investment. You simply place a 30-year mortgage on an investment property and pay it off like it is a 15-year mortgage. I am neither for nor against this strategy, I just do not use it myself for the reasons I will expand on below. I know as I write this that there will be some readers who will comment that yes, this is the precise strategy that they use and that they calculate each month exactly how much

It takes tremendous self-discipline to be able to make that strategy work and I have met many investors who claim this will be their strategy only to find that they like bragging about higher cash flow more than they like bragging about owning the property. The discipline it takes to carry out this strategy is often missing from many investors. Put Your Self In Position To Own Your Property Outright As I stated earlier, the better strategy and the one that I am seeing more investors come around to is using leverage to purchase properties, but not necessarily carrying that leverage for long periods of time. In fact, many investors are choosing to structure deals so that they are paying off the properties as soon as possible. Investors taking this route are usually financially secure and are not necessarily real estate investors. Often times, they recognize the need to diversify into real estate, but are often passive investors looking for the security and consistent return that real estate can give them. They see real estate as a secure investment and rental properties as a product that will have continued demand in the
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...I am seeing more investors come around to using leverage to purchase properties and cash to hold them long-term.
come back to bite you on investment properties. Another major point that I missed when I first started investing and has been taught to me over the years from some investors much smarter than me, was that for the first 25 years of my ownership of that property, I would money to pay to reduce the principle each month. They feel that they get a lower rate since a 15-year mortgage can cost as much as .25 to a .50 point more. To those readers that follow this strategy and actually follow through on this strategy, I will say that I believe you are in the minority and congratulations!

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foreseeable future. I have a good friend here in Tennessee who is a very successful executive and he has recently made moves to acquire property as he seeks to diversify. When he and I had lunch, he explained his very reasoning and his absolute distaste for taking on credit risks and leverage. This is a common theme among more and more affluent investors looking to diversify. They are using several different strategies to purchase the properties. 1. They are purchasing properties for cash and holding for a consistent rate of return recognizing that they can place minimal financing against the property in the future to assist with leveraging a larger portfolio. 2. They are purchasing property using a 15-year mortgage. They then take the cash flow each month and use it to reduce the principle. In some cases, this can reduce the term of the loan to less than eight years. 3. They are structuring the term of the loan to match the monthly note to the rental amount received. 4. They are purchasing using a mixed bag of options including cash purchases, refinancing existing properties at low leverage, bundling a portfolio to acquire leverage for new properties. Regardless of the scenario that investors are following, they are using leverage to increase their purchasing ability and using the cash flow produced from each investment property to reduce the principle. The idea behind affluent investors purchasing plans are to own the assets outright in the shortest amount of time. This enables them to keep as much of the return on the investment as possible. The Single Biggest Expense In A Leveraged Property They recognize that there is only one fixed expense that the investor can be in direct control of and that is interest. Management, taxes and insurance are all fixed costs, which the investor has little to no control over. Vacancy is a variable cost that even with the most prudent management is going to affect an investor at some point and there is nothing an investor can do to prevent. Routine maintenance and major replacement costs are also variable costs that, while an investor can prepare for and take steps to reduce, there is still little an investor can do to limit and nothing an investor can do to eliminate these costs. That leaves interest costs as the only major expense that an investor has control over as it relates to earnings potential on a property. Many investors that I am talking to today are choosing to do everything possible to reduce the over-all costs of interest including choosing higher interest rates to secure shorter terms
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and buying cash flow properties not for the cash flow, but to purchase more properties faster. I want to make sure everyone caught that last sentence. While in San Francisco, this was a big point I was trying to get across to the audience and based on their reaction, it made sense to them. How I Buy Properties As an investor, I believe in buying properties that make sense based on what I have experienced as an investor. I have bought junk properties. I have bought cheap properties. I have bought properties and done the minimal amount of work to get them rent ready. I have bought properties with creative financing such as ARM mortgages and even bought a couple with interest-only loans. Every one of those strategies was aimed at producing Higher Monthly Cash Flow. And every one of those strategies almost sunk me completely as an investor. Today, I buy properties where the fundamental economics make sense. I told the crowd in San Francisco that when

buying properties that produce a monthly positive cash flow, they should consider using that money to reduce principle. I cautioned them that if they were attracted to real estate and cash flow because they needed to pay bills, then, in my opinion, they really needed to be positive they were getting sound financial planning before buying. I told them that in my opinion, real estate purchased for buy and hold is a great way to build and maintain long-term wealth, but a lousy way to earn short-term money. I told them that real estate has the greatest pay-off when you own it outright and that as an investor, getting to that point should be your highest priority. Using leverage to build your long-term portfolio is a great tactic. Using leverage to build your short-term monthly cash flow is not. Am I off my rocker? Am I spot on? Let me know what you think Chris D. Clothier is a Partner at MemphisInvest.com and Premier Property Management Group. He can be reached at: chris@memphisinvest.com or 901-751-7191.
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