23: Should You Pay Off Debt on Rental Property?

This week’s wealth widget addresses the following question from one of our listeners, Craig.

Dear Buck,

I have been a real estate investor for over 40 years now. It seems to me that there are two schools of real estate investors.

One school is a Dave Ramsey strategy of paying the properties off and be debt-free. The other strategy is to leverage constantly until the day you die.

Please tell me what you think about both strategies giving both pros and cons for each strategy.

Thank you.

Craig

First of all, thank you for your question, Craig. I’m curious which strategy you have using all these years and why.

Let me give you my take. As you know, I pride myself on focusing on wealth creation in general. I’m not just a “real estate guy”.

HOWEVER, it is my opinion that real estate is, in fact, the most powerful wealth creating asset available to professionals like us. For that reason, I invest no less than 70 percent of my own investable assets into real estate.

Why do I think it is so powerful? First of all, it is real. It does not vanish because of Lehman Brothers collapses nor does it react when there is political discord half way around the world.

The same could be said about gold or other precious metals, right? True, but gold does not throw off cash flow. Gold is money. Cash flow is another virtue of real estate when done the Wealth Formula way.

Another benefit of real estate is that, over long periods of time, real estate holds its value with inflation and, in many cases, exceeds the rate of inflation in terms of appreciation.

That said, an ounce of gold in Roman times bought you a nice toga and a pair of sandals. Today, an ounce of gold buys you a nice suit and a pair of shoes. That’s a pretty good measure of wealth preservation in my view.

Where real estate really excels in terms of the opportunity to create wealth is through leverage. Leverage simply means using other people’s money (OPM). Most commonly, those other people are the bank.

So, say I’m buying a $100,000 rental property. Furthermore, let’s say that rental property, after all expenses, generates $10,000 per year. The return on investment per year would then be calculated as 10,000/100,000 or 10 percent.

Another word for return on investment in real estate when no leverage is used is the “capitalization rate” or simply cap rate.

Now let’s say that instead of buying that $100,000 property with our savings, we use the bank to leverage in the form of a mortgage. As long as the interest rate offered by the bank is LESS than the cap rate, it will end up with a higher over-all return on investment.

In fact, I have a mortgage on an apartment building that has a capitalization rate of 10 but my annualized return on investment, because of the leverage, is actually about 20 percent.

Ok, so let’s do the math. If you bought that one building with your $100,000 savings, you would end up with $10,000 at the end of the year. However, if your leverage created the kind of increased return on investment I referenced above with my own apartment building, then you could buy five $100,000 properties with five down payments of $20,000 apiece.

At the end of the year, you could either have one unleveraged rental property with $10,000 return OR you could have five leveraged properties with $20,000 return on investment. Obviously, the latter will sound more appealing to most of you.

Now, back to our initial question about whether you try to pay down the debt and hold these properties free and clear.

You now have five rental properties each with an $80,000. The question is do you try to pay off these mortgages? If you do, you have the advantage of increasing your absolute cash flow. That’s not a bad thing.

However, that’s not what I would do. Here are a few reasons why.

The more leverage you have, the higher your return on investment. We demonstrated that above by showing why you might rather leverage than not leverage your initial purchase. Paying off the mortgage early reverses the benefit of the leverage you got in the first place.

1) Paying down a mortgage increases the equity you have in a property. That sounds great. You can brag about your balance sheet to your friends. But why would you want that? Too much equity in a property renders that money effectively dead and makes you a great big target to creditors and others who may want to sue you. Mortgages and liens are great for asset protection.

2) As stated above, money in the form of equity that is trapped in a property cannot be used to make more money. When you refinance and take equity out of a property, you can redeploy your profits quickly (velocity) and you can buy more property with more leverage. Leverage and velocity are the pillars of wealth creation. Without them, it is very difficult to become wealthy.

3) The more leverage you have, the more you can enjoy leveraged appreciation. It is a speculative component but historical fact of real estate. The trajectory is up. If your equity in a $100,000 property is $20,000 and it appreciates $200,000, your returns are going to be much higher than if you paid down an $80,000 mortgage and have $100,000 equity in that property that appreciated to $200,000.

4) INFLATION ERODES DEBT. The national debt is about $20 Trillion right now. How do we even start to pay that off in an anemic economy? Well, we can either figure out a better way of controlling our expenses and start paying it down OR we can erode it by making it worth less. Inflation makes debt worth less by decreasing its real value. That’s why we MUST have inflation in this country. We need to pay our bills! If inflation erodes debt, why in the world would you want to pay off your mortgage? Wouldn’t it be even better if it just washed away with inflation?

Now, this was a very long-winded answer to Craig’s question but hopefully you found some value in going through this exercise with me.

It is my strong belief that velocity and leverage are the critical elements of wealth creation. I should add that this is the reason I am so bullish on utilizing Wealth Formula Banking to further amplify returns with these principles. You can still watch that webinar and learn how by going to wealthformulabanking.com

Finally, despite the fact that I am such a huge proponent in the power of leverage, I must remind you that with power comes responsibility. Leverage used carelessly can quickly become a force for financial evil. So, we have to educate ourselves and unleash the power of leverage carefully and responsibly. But when used properly, leverage can be a beautiful thing!