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Why You Should Pay Cash for an Investment Property (or pay it off as soon as possible)

Paying cash for a house – that sounds crazy, right?  But it can be done, especially when you are talking about an investment property.  I will discuss the strategy further down in the article.  But why even discuss this?  Isn’t leverage the only way to get ahead in investment real estate?  Not necessarily.  There are multiple approaches to building wealth in real estate.  We here at Entre-Realty advocate for a debt free approach to real estate investing.  Why?  Because it simplifies your life immensely.  If you have no mortgage payment on your rental property, and only need to pay the annual insurance premium and property taxes, your property could go unrented for several months without creating negative cash flow.  Now flip that to a more normal scenario: a couple that decides a rental property will be great additional investment outside of the stock market.  But this couple has car payments, credit card payments, student loan payments and a mortgage on their own primary home.  Now they want to add another mortgage payment to their monthly bills.  If this couple is smart, they recognize that their own primary residence requires routine and emergency maintenance that costs several hundreds or thousands of dollars per year, so their investment property will require the same (if not more) level of maintenance and have some extra cash as emergency savings for these additional expenses.  What happens to this couple if they cannot get a tenant to move in for months; or worse, accept the first tenant they screen because they need anyone in their rental as fast as possible.  Worst case, this tenant does not pay for several months, the owners file for an eviction, and the tenant trashes the property before leaving.  This couple has lost months of rent and incur thousands of dollars in repairs before they can get the property rented again.  These are not expenses a normal, in debt couple can cope with, and get them into some real financial trouble.  On average, a rental property with a mortgage, property taxes, insurance, and annual maintenance costs only clear an average of $100 per month, but is it worth the stress?

Let’s look at an extreme case study on how over-leverage  ended in bankruptcy.  According to the author, he “went from a 4,000 square foot home, worth more than $1 million, a vacation home, new RV, Mercedes convertible, Jeep, $50,000 SUV, 20 rental properties, a property management company and a great full time job…   To living in a modest rental house in the middle of nowhere.”  When you read the article, you will see that his over-leveraged real estate empire was a house of cards.  After facing a tax audit and the real estate crash in 2006-2008, all of his properties were foreclosed, including his primary residence, and he went into bankruptcy and lost his job.  He details the shame and embarrassment his family went through during this process.  I am sure it was extremely stressful for them as well.  An outsider looking in on this person before it all came tumbling down would have thought he was a multi-millionaire; someone who had it all.  Debt was a tool he used to make himself successful, for a while.  But in the end, it came back to bite him severely. 

On the opposite side of the debt spectrum is the debt free approach to investing in real estate.  We paid cash for a house and inherited tenants.  As part of the transaction, we decided to honor the existing lease agreement between the previous owner and tenant (an article for another day).  We met the tenants and built, what we felt, was a good rapport between us.  Unfortunately, the tenant ended up not paying rent for two months.  We had allowed for some leeway due to a job situation, but in the end, we evicted the tenant which took another 20 days.  Total amount of rent lost was 3 months, plus turn over costs.  If we had a mortgage on this property, we would have been stressed.  But being debt free allowed us to offer grace to this tenant, and although in the end he never paid and was evicted, our conscience is clear and it did not have a major financial impact or stress on our lives.

So what do we recommend?  If you are thinking of buying a rental/investment property, we recommend being debt free, to include your primary residence, and have a healthy emergency fund first.  Does this mean you can’t get a jump start on your retirement plan?  No! As soon as you get out of consumer debt and have your emergency fund in place, start investing 15% if your income in retirement accounts (401K, 403b, IRA/Roth IRA).  Once you are debt free, you should have income free to invest for your future as well as extra income remaining to pay down the mortgage on your primary residence as fast as possible.  Once you pay off your primary mortgage, start building up cash to buy a rental property.  You don’t have to spend hundreds of thousands of dollars on a rental property.  Remember, tenants won’t take as good of care of the property as you would because they are temporary residents.  There will be wear and tear, so you don’t need high end marble and granite in the house.  Depending on your real estate market, you can find quality homes (that will probably require some structural or cosmetic work) for under $100K after all costs and can rent for $1000/month or more.  In Greenville, we found one property for $55,000, put in about $30,000 of work into it, and rent it out for over $1200/month.  The annual cash on cash return after property taxes and insurance is over 15%!  Cheap properties does not always equate to profitable properties, but you can find quality properties for a bargain if you know where to look.

What if you have consumer debt, a primary mortgage, and/or a mortgage on a rental property?  Get out of debt as soon as possible!  Find a way to increase your income, through extra jobs or selling stuff you don’t use (or especially sell things that have payments attached).  Sell the rental property and use the proceeds to pay off your other debt and build up an emergency fund.  Then build up a hefty cash reserve to pay 100% down on a rental property.  If not, is your financial security, your relationship with your spouse, the extra stress in your life really worth the extra $100 a month most average people bring in from their mortgaged rental property?