Consider the following scenario.
You meet a friend for lunch, and he is very excited about a real estate purchase on which he just closed. He is now the proud owner of a fully tenanted apartment building, located in a great part of town. Then he delivers the piece de resistance. “I paid all cash for it!” he announces. “This investment is practically risk-free!”
You congratulate your friend, impressed that he had cash on hand to pay for the property. However, your friend is incorrect about the risk level of his just-acquired asset. Certainly, he owns the property free and clear, meaning he isn’t beholden to a lending institution, or facing the possibility of foreclosure. The investment still carries risks, however, partly due to the nature of real estate ownership.
Specifically, an asset that is free of debt doesn’t make it free from risk. There are times, in fact, when arranging for financing on a real estate investment can be preferable to writing a check for the full amount.
Debt Free -- Still Means Risk
Before discussing the pros and cons of an all-cash purchase versus a loan placement, let’s delve into the issue of risk. We’ve actually discussed this topic in previous blogs, defining risk as:
“. . . potential uncertainty and/or financial loss when it comes to an investment decision or activities. The higher the degree of risk, the higher the returns are likely to be . . .”
Risk, in and of itself, isn’t inherently bad. It simply represents how much an investor is willing to lose, in anticipation of receiving a greater reward. The general rule of thumb is that the higher the risk level, the greater the reward potential.
Now, when it comes to real estate, the risk/reward concept is more complex. This is because many external factors can impact the value of a real estate asset. Getting back to your friend and his apartment complex, his “practically risk-free” investment is subject to market forces, such as supply and demand, as well as rent and tenant volatility.
Unexpected expenses are also a risk when it comes to real estate ownership. If, for example, the roof of your friend’s property blows off in a storm, he must come up with the funds to replace it. If he doesn’t have enough capital stashed away (because remember, he paid all cash for that property), he could be too slow with his roof repairs. If, two months later, a tarp still tops his building, he could lose tenants, especially depending on the area’s supply. This, in turn, would impact his cash flow.
Adding to this, your friend could have trouble getting new tenants, especially if his apartment building is getting negative reviews on Yelp and other review sites. This might force your friend to charge lower rents in an attempt to attract tenants, resulting in a lower rate of return on his investment.
In short, for all of his boasts about a practically risk-free investment, your friend’s scenario has actually only eliminated one element of risk - financing risk. Assuming risk and return are related, the question becomes, how much potential return was sacrificed, in an effort to reduce or eliminate the risk associated with financing? Certainly, identifying and managing risk is paramount to successful real estate investing. In addition, investors should also understand if they are being adequately compensated on a risk-adjusted basis.
Utilizing Debt -- Its Risks and Rewards
Let’s take a look at what might have happened, had your friend opted to take out a mortgage on the property, rather than paying all cash. The potential risks he faced might have included:
- Requirements to meet debt service payment obligations, regardless of property cash flow
- Interest rate fluctuations, depending on the mortgage type and structure
- Potential foreclosure, if unable to maintain mortgage obligations
- Conceivable personal recourse in the event of loan default
- Possible limitations on securing additional financing
In light of the above, your friend might have decided that avoiding the bank would be a no-brainer. However, if your friend had done a better job of evaluating the risk, he might have realized the following benefits from applying for, and receiving, a mortgage.
Tax shelter availability. One main benefit of a mortgage is the ability to deduct its interest when tax time comes around. This can be a meaningful, though often overlooked benefit, especially when comparing risk-adjusted returns on an after-tax basis.
Capital availability. If your friend puts a down payment on the property and finances the remainder, he has more money available for repairs, maintenance, and property upgrades. Upgrades have the potential to increase the property’s value, meaning a greater rate of return when your friend decides to sell. Depending on your friend’s personal financial situation, this move could also have allowed him to maintain greater liquidity to deal with unforeseen circumstances with the property or elsewhere in his life.
Portfolio diversity. Your friend can take his leftover capital, and invest it in other properties, thus spreading his risk. For example, even if his roofless apartment property means rent reduction, other properties in which he might have invested (hopefully in less windy areas) could continue providing a steady cash flow.
Potential appreciation increase. Debt can have the ability to magnify appreciation to investors. If your friend had financed his property with 75% leverage (in other words, the mortgage represents 75% of the entire purchase payment), a 5% increase in the property’s value would result in a 20% increase in equity to the investor. The risk here is that the opposite is true, as well, if the property’s value decreases.
Debt, Cash, and Degrees of Risk
Put quite simply, debt-free does not mean risk-free. In paying all cash for the apartment building, your friend faces certain risks. If he had decided to borrow funds for the acquisition, he would have faced a different set of hazards.
The issue here isn’t whether all cash is better (or worse) than financing. Rather, investors, such as your friend, should make an honest assessment of the upsides and downsides of funding real estate acquisitions, then determine if the potential risks and rewards are worth it. Through such an analysis, your friend can better determine actions that will meet his investment objectives, while taking into account his risk tolerance.
To learn more about investing in real estate, contact Realized Holdings by logging on to www.realized1031.com, or by calling 877.797.1031.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor.
There is no guarantee that the investment objectives of any particular program will be achieved.
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