Eleven years ago I heard a successful real estate investor observe, “You don’t save your way to retirement; you borrow your way to retirement.” Up until then I’d never heard it expressed quite so succinctly. Of course he was talking about the power of debt or leverage in helping an investor to build a portfolio of income properties that would otherwise be beyond his means. The concept was that if an investor can ride out the debt while the property’s income gradually pays off the debt he will have built equity and income that by himself he would not have otherwise been able to afford. This can be a short cut to retirement in the field of real estate investment and in many other areas of investment. But too much debt at the wrong price or at the wrong time or on the wrong property can also be a quick road to insolvency.
Later as I pondered on his expression of wisdom I thought, “But first you must be a saver in order to have the down payment.” Some would argue that you can find “no money down” deals, and therefore, you don’t even need to save the down payment. But, from what I’ve observed, the investor who builds and keeps some liquidity is more likely to survive the vicissitudes of a fluctuating real estate market than the man who simply pyramids debt.
My sons might be confused to hear me espouse debt when they have heard me preach so often about the value of getting out of debt. I prefer to carry little or no personal debt. However, in looking back over the history of my investment career I have to admit that I have leveraged my home several times in order to augment the down payment on a piece of investment real estate. I like to believe I was judicious in doing so and that I took measured risks, but several times that leverage turned on me when there were unexpected changes in the economy and/or in my career and/or earned income stream(s). There were times that I questioned the wisdom in taking on the debt or risk that I had acquired. There were even times when I came close to facing insolvency because of too much debt in a bad economy.
Once debt was acquired I usually found myself tormented by it, and working feverishly to pay it off. Little by little that effort built more capital and gave me more control in my investments. At that point other investors would look at my portfolio and ask, “Why don’t you carry more leverage?” My reply was, “My leverage now is my own capital working for me. To a small extent I have become my own bank for some of these investments.” Even so, when the real estate market collapsed in 2007 to 2008 I found myself jumping back into debt in order to capture a great price on an undervalued property. It was a risk, but it seems to be coming along nicely now.
It’s true that we have all seen people simply save their way to sufficient retirement wealth by making intelligent stock picks and by constantly and regularly adding to their savings. Some have achieved sufficient wealth for a comfortable retirement without resorting to leverage. In the real estate market this is hard to do, because it is difficult to save enough to buy even one or two small pieces of property for most people. If a real estate investor wishes to accelerate his results he inevitably turns to leverage.
One of the best pieces of advice for the would-be real estate investor is to buy when the market is down as that is when they are most likely to find an under market price. As the market comes back thereafter the debt burden is easily carried by the income the property produces. Risk and worry are thusly avoided to some degree. In my mind, the best time to add leverage is when the real estate market has crashed, when the market is bottoming, and when the banks have dropped interest rates to encourage investors. At that point, there are price deals in the market and the interest rates and loan term planets have aligned. It takes patience and timing to supercharge your investments. There are times (such as the peak of the market) when it may not make sense to be a buyer. I’m sure you’ve heard the dictum, “Buy into weakness and sell into strength.” That’s what timing is all about. It is possible, to some extent, to time the real estate market.
Recently I was discussing the value of paying off a home with one of my sons and also with a friend of one of my sons. As we individually looked at the numbers they explained to me that with interest rates as low as they are they might actually be smarter to invest in something that would pay them a better rate of return than retiring a 3.75% interest rate debt. Having grown up with 9-12% interest rates it usually made economic sense to me to pay down debt (at least on the front end of a mortgage). Things had changed and the circumstances were different. It made me stop and think. Part of me was thinking, “The time to hammer the debt principal is while interest rates are low. That’s the only time when you might have the extra cash to do so. Then you won’t later find yourself in a position of needing to refinance a large balance when interest rates are high.” The other part of me was saying, “Build capital where the return is better and later you’ll have the money to pay off your mortgage.” One can argue back and forth endlessly on what is the best course, and it can change depending on the totality of existing circumstances.
Past generations have strived to retire the family’s home mortgage as early as possible in order to ensure a lower cost of living in retirement. This, in turn, meant that a person living in a fully paid off home could live off the income from a smaller pot of capital than the person whose home was still mortgaged when the age of retirement arrived.
Is it possible to do both, to pay off the home and still build sufficient capital to retire? Yes. To do that requires that a person build sufficient income streams to finance both efforts. It requires careful financial planning and paying constant attention to where capital is applied. It requires adjustments in the plan to accommodate changes in personal income and/or in the markets.
One thing is for sure, these things will not happen without goals, without plans supporting those goals, and without the disciplined implementation of those plans over time. It is possible, and perhaps even necessary, to juggle and implement multiple plans during the same time period. It is important to start early on this journey and make commitments with your capital that will provide for your later years.
Many investors work towards becoming debt free in their personal lives even as they take on new debt on new properties in their investment lives. That sounds like double talk, but it’s the way of real estate investment. Many savvy real estate investors leverage up when buying and/or renovating a property, but once they own the property they carefully apply the profits to the mortgage in order to reduce risk, to eventually eliminate the mortgage expense, to reduce the total interest paid, and to increase their equity.
To leverage or not to leverage, that is the question.