When I have previously outlined our Blueprint real estate investing strategy, I have usually given examples that involved the leveraged acquisition of quality assets followed by an aggressive campaign of debt elimination to produce maximum cashflow at retirement. But as crucial as smart leverage can be to the investing success of some investors following our strategy, it is not required or necessary. At its very essence, our Blueprint is the road map from where you currently are to where you are trying to go at the end of your investment horizon. So in that spirit, the right investment strategy for you is determined and shaped by your current financial situation. For instance, an investor with limited capital will follow a very different path to retirement than another investor with a large enough capital base to generate sufficient debt-free income to retire tomorrow.
Next, let’s take a deeper look into the main reasons and motivations that push some real estate investors to the path of debt free real estate investing for income and appreciation.
Risk aversion to debt
Most investors that make the choice to avoid leverage completely do so to avoid the perceived risk that debt inevitably adds to their portfolio. And it does not matter that the added risk is usually accompanied by a higher, leveraged return on investment. A very conservative investor is content with a lower rate of return if they can avoid the risk of financing. They view leverage not as a temporary tool to grow your capital base in a shorter amount of time but as a fatal risk that could bring the whole thing down. And often they have the time and/or the patience to build their wealth at a slower pace as long as it’s done within their risk comfort zone. This isn’t neither right nor wrong – every investor should operate within “comfortable” risk and return levels. In the end, it does not matter how good is the return on your investment if you perceive it so risky that you can’t sleep at night.
Lack of access to investment property financing
The investor that sidesteps debt due to this reason does so out of necessity, not choice. Take as an illustration a 58 year old teacher that takes early retirement and has some liquid capital to invest. He gets a pension every month but it’s not enough to fully retire. And also it’s not enough to qualify for financing on an investment property. In this case, the only available option to this investor would be an all cash strategy to increase his monthly income through some well placed real estate investments. Another example would be that of a newly minted entrepreneur that just ditched his corporate shackles with plenty of capital to invest but with no regular 9-5 income to qualify for financing.
Lack of need for financing
In this case, the investor already has a large enough capital base that the unleveraged yield on that capital is sufficient to provide the income she’s seeking. File this under, “good problem to have”. Say you have an investor that has $1.5M in liquid capital to invest and they’re trying to create an income stream of $120k per year. This investor has no need to leverage that capital further – she could purchase $1.5M in paid off real estate and reach her desired income right away.
Lack of necessary time
One critical ingredient in the utilization of leverage as a tool to grow one’s capital base is time. Without sufficient time to execute a proper debt pay off, leveraging your capital is simply risk for the sake of risk. You should only take calculated risks if you have a) an exact idea on how to eradicate that risk as soon as possible and b) sufficient time to carry out that idea. As an example, take a 65 year old investor that needed to retire last Friday at 11:30 – he just doesn’t have the time to execute a plan that involves the undertaking and paying off of leverage. The only option left is to use the capital that he has accumulated and generate the highest yield possible on quality asset(s).
The numbers
Now that we figured out some of the reasons why an investor would choose (or be forced down) the path of all cash real estate investing, let’s take a look at some of the numbers. Since the investor is not utilizing leverage, her return comes from exactly two places: Yield on capital and Appreciation. Yield on capital sounds like a big ten dollar term right out of a finance textbook but it’s actually pretty simple. If I purchase a property all cash for $140k, and after paying all operating expenses I have $11.5k in cashflow left over at the end of the year, my yield on my invested capital for the year is 8.2% (11.5k/140k). It would be the same as you going to the bank to open a CD where you put $140k and the bank pays you $11.5k in interest at the end of the year. Except that your banker would think you are on something if you asked for an 8.2% return these days! Depending on the relationship between the acquisition price and the incoming rent of the asset you acquire, your yield on capital on free and clear investment properties will vary from 7-9% annually.
On the lower end of that spectrum, you will find premium properties in highly desirable locations that are in high demand – which results in higher acquisition prices and lower yield. The higher end yield will come from more standard properties in good locations. But here’s where it gets interesting – the properties that produce lower yields have a higher potential for appreciation than their counterparts. So when it’s said and done, opting for a premium property at a lower yield may end up giving you a higher overall return. But in the end, it all comes down to the needs of the investor: If the investor is mostly concerned with income, the higher appreciation may not matter as they may never sell the property to realize it. Otherwise, if they’re just opting for an all cash strategy to avoid risk, going for higher quality assets may result in higher returns and lower risks over time – a pretty rare combination.
Last but not least, cash is still King – a generous monarch that at times allows an investor the patience to pursue and negotiate bargains on quality properties. This could be a dual boost to returns: 1) It would allow the investor to acquire the same income stream for a lower purchase price therefore increasing her yield and 2) the built in equity captured at purchase can act as instantaneous “appreciation” that can be tapped later. The challenge with pursuing bargains is to never lose sight of the quality of the asset you are purchasing. An inferior asset at a great price is not a quality asset. So as long as property standards aren’t compromised, patient chasing of good deals is the recommended route.
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Are you interested in debt free real estate investing? I can help lead you in the right direction. 713-922-2702 is my cell. Or if you prefer email, Contact Us
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