Why Leverage is a MUST in Real Estate Investment?
In the investors’ world, “Cash is the King” is not only a slogan. It is a revered universal rule. Warrant Buffet, the ultimate investment guru and unarguably the most successful investor of the last century, is known to keep cash positions when he does not see a good buy. In the real estate investment world, the rule of the game is the same. Over leveraging is a killer for so many real estate developers especially in times of economic recession or rising interest rate environment. 2009 and 2022 were two recent years that we saw so many catastrophic falls.
Does that mean we should pay all cash when we buy investment real estate property? As a seasoned Tax Accountant, from a tax efficient perspective, I will not agree with that strategy. I believe Leverage is a MUST in Real Estate Investment. The key is how much you should leverage, it is not whether you should leverage.
Let me give you a simple example to illustrate my point:
Let’s start with 4 assumptions:
You have $1 Million cash on hand to invest in Real Estate.
Cap Rate is 7% (a common return in Chicago Multi-Family market)
Borrowing cost is 6.5% with 30-year amortization.
You are high earner at the highest tax bracket (37% + 3.8 NIT + State Tax = 50%)
Here are two ways to do it:
1, All Cash Investment
Purchase a $1 Million 3 flat in the Chicago Bucktown neighborhood. Your net cash flow (after deducting property tax, property insurance, property management fee, repair and maintenance) every year will be $70,000. Tax time comes, you need to pay tax on $40,000 (we can deduct about $30,000 in depreciation) which is $20,000. Your net take home cash flow will be $50,000, which makes your TEY (Tax Equivalent Yield) of this investment to be 5%.
2. Leverage
Put $1M down, borrow $3M and purchase Four $1M 3 flats in the same neighborhood. Now, you have an extra expense of Mortgage Payment of $227,500, which includes $195,000 in interest payment and $32,500 in principal pay-down.
If we consider Interest Expense only, your first-year additional expense will be $195,000 ($3,000,000 X 6.5%), your first-year net operating income will be $280,000 ($70,000 X 4). So, your net income will be $85,000, not too much higher than the $70,000 in scenario one. But, when tax time comes, we will have $120,000 phantom depreciation expenses to deduct which will make our taxable income to be negative ($85,000 - $120,000 = -$35,000). You definitely do not have to pay any taxes on your $85,000 net income, so you get to keep all that money and TEY jumps up to 8.5%.
If we take a cash flow perspective (which most investors prefer), we will need to add Principal payment as an expense in the P&L. First-Year Net cash flow will be $52,500. It seems a bit lower than scenario 1 (which has $70,000 in net cash flow). But as soon as we factor in the $20,000 tax payment to uncle Sam, this option is still better. And every seasoned investor understands that Cash on cash improves over the year due to the rental income increase over the year and the equity build up.
Through this simple exercise, I hope I have won you over. Due to the fact that your interest expense is fully deductible (not subject to the $750,000 home mortgage interest deduction ceiling) and the increased depreciation expenses arising from a bigger portfolio, your TEY is much higher if you leverage.
Is Leverage Still a Smart Move in High-Interest Environments?
Leveraging is one of the main reasons why Real Estate Investment is better than a lot of other investment categories. Aside from improving the TEY, you also enjoy a much bigger real estate portfolio. You are using other people’s money to make money, isn’t that an investor’s dream? If we factor in Appreciation into this calculation, the bigger your portfolio, the bigger the gain, right? Over my 30 years of practice, I witnessed a lot of my clients accumulated generational wealth through steady real estate investment leveraging other people’s money.If you have massive “unused passive loss” from your other real estate activities (due to your high income), you can simply use that loss to offset your gain.
H0w Much Should I Leverage?
Now we established that paying all cash is not very tax smart in investing real estate, should we leverage it to the brim? From a simple mathematical point, the more you leverage, the better it is. But no lender will lend you 100% any more. Also, borrowing cost is a real cost, especially when the borrowing cost is higher than your Cap Rate, it will actually eat away your return. Like everything else in life, balancing is the key. Make sure you get the best rate the lender can offer. From my experience, anywhere between 70-80% LTV (loan to value ratio) is the ideal spot, which means you should put down 20-30% to achieve the best borrowing cost and best leveraging effect.
Creative Financing Tools
Another topic I touch upon a lot with my clients is where you can obtain a large down payment to purchase your first investment property? Most people’s biggest asset is Equity in their home and Retirement Account. Disclaimer: I am not a Financial Advisor; I am a Tax Advisor. You need to consult a Financial Advisor about your asset allocation and your personal financial goal, but the two strategies I suggested here do have great tax advantage:
Home Equity Loan on your primary residence can be used as down payment to purchase investment real estate. As long as you keep accounting clean, all the interest you pay can be used as an operating expense and it is not subject to the Mortgage Interest deductible celling.
Set up a Solo 401K with your real estate investment business and roll over your retirement funds. You can then either borrow money from that Solo 401K as down payment or you can even self-direct that 401K and invest in the Real Estate directly.
Summary
Tax strategies are infinite, please make sure to find a good Tax Accountant who will not only file your taxes every year. You need someone who can strategize with you to leverage the tax code and help you accumulate Tax Free wealth. If you have any question, please request a consultation with me and I am happy to help!
Justine Zhou
Justine Zhou is the CEO of Zhou Agency. She is also a senior CPA and extremely knowledgeable advisor with well-rounded expertise in tax, real estate investment and insurance services.
Justine believes in understanding clients’ needs first and providing tailored consultation to clients’ unique situation. She uses language that the audience can easily understand and is good at incorporating her expertise in both tax & real estate to help real estate investors achieve maximum tax savings.
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This post is to be used for informational purpose only and does not constitute legal, business, or tax advice. Each person should consult his or her own accountant, attorney, or business advisor with respect to matters referenced in this post. Zhou Agency assumes no liability for actions taken in reliance upon the information contained herein.
