Wednesday, April 16, 2014

Leverage or cash which is better?

Leverage has always been one reason folks buy real estate. It allows homebuyers to own and control an asset worth hundreds of thousands of dollars for as little as a 5 or 10 percent down payment. Try that the next time you decide to purchase a few shares of stock, municipal bonds or commodities. Leverage allows buyers to use a small amount of their own money, with the lender providing the majority. This benefits both buyers and sellers. Imagine what would happen to property values if there were no leveraged lender financing. All sales would need to be either owner financed or cash sales. A frightening thought.

Leverage not only makes it easier to buy homes and investment properties but it has other benefits. Homebuyers may only have a small percentage of their own money invested into the purchase but they receive 100 percent of the benefits of ownership.

Our tax code favors leveraged investors who may only have a small equity position in their property but are allowed to depreciate 100 percent of its acquisition price. By using leverage, an investor may preserve more of their cash and buy more properties. This strategy, of having multiple properties all gaining value, works well in an appreciating environment. In the event of catastrophe and loss of the property, it is considered better to lose a highly leveraged property than one with that has a significant amount of an owner’s cash invested.

A few years ago, when property values were increasing at unprecedented rates, lenders were offering a plethora of leveraged financing options. Borrowers could leverage themselves 100 percent into the purchase of a home without any down payment. Interest rates were leveraged with low adjustable rate mortgages and some borrowers leveraged the terms of a loan by choosing a negative amortization loan, where the borrowers’ monthly payment was less than the interest. After all, leveraging was smart. It was hip and everyone was leveraged with mortgages and credit cards. The rest is history.

Leverage has a price. The less money a borrower has invested in a home, the higher their monthly payment. Highly leveraged homebuyers, those with less than 20 percent down payment, will generally be required to pay for mortgage insurance and often have a higher interest rate.  Highly leveraged investors will have reduced cash flow and may experience financial stress in the event of a vacancy.

An interesting phenomenon today is that many homebuyers and investors are going all in on their purchases. They are paying all cash without any leverage. According to a monthly report from the National Association of Realtors, 30 percent of all sales across the country are for cash, involving no financing. The percentage is higher in California where 35 percent of all residential sales are for cash. Buyers have transitioned from a preference for high leverage to high equity. What’s up with that?

The shortage of inventory has upped the ante for anyone wanting to play the “I want to buy a house” game. It takes full price or better to open and cash buyers have an ace. Cash will trump higher price offers that are contingent upon financing or an appraisal.

Buying real estate for cash is a good play for many cautious investors who remember the Dow plunging from its high of 14,164 in October of 2007 to 6,594, 18 months later. Although borrowing is at historical low interest rates so are earnings on conservative investments such as Federal Treasury notes and bank certificates of deposit. Anyone who is receiving less than 3 percent on their cash is actually losing money due to inflation.

There is no hassle when buying with cash. It’s easy. When financing a home purchase, it involves a number of unknown people investigating every aspect of a purchaser’s financial life. It is a long and complex process. Some buyers prefer to skip all the red tape and just write the check.

Over the last seven years we have witnessed the collapse of the stock market, the bursting of the housing bubble, the federal takeover of housing financial giants Fannie Mae and Freddie Mac, the federal bailout of Wall Street and the auto industry, the Great Recession, millions of folks out of work and millions of foreclosures and short sales. This economic turmoil has provided a new appreciation for having a large amount of equity in a stable secure investment like a home or small rental property.

Not everyone has the option of buying for cash; however, homeowners are taking other steps to increase their equity position as quickly as they can. Buyers are increasing their down payment. The average down payment has doubled in the last six years. Refinancing to extract equity from a home, called “cash out” refinancing has dropped 70 percent from 2006 levels. Borrowers are now refinancing to a lower interest rate with 15- and 20-year mortgages. Others are making an extra monthly payment.

Americans look differently at leveraged purchases toady than what we did a few years ago. Just as 9/11 changed our attitude about personal freedoms versus security, I suspect the Great Recession has changed our feeling about leverage and equity.

Ken Calhoon is a real estate broker in El Dorado County. He can be reached through his Website:


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