Surprising Investors with Sound Advice on Leverage


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Chris Clothier is one of the most successful investors in the industry. As co-owner of Memphis Invest, Chris and his family manage millions of dollars worth of rental real estate for clients around the world. Read his new article!

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Surprising Investors with Sound Advice on Leverage

  1. 1. “Smart real estate investorsare learning to use leveragewisely and efficiently to putmore money in their pockets.”Continued on pg. 58Real estate investors are being bombarded withadvice today from every direction and it issometimes hard to find two pieces of advice thatare the same. There are so many options and somany opportunities that becoming confused isa common feeling among investors. Well get ready, becausehere comes one more piece of advice that may run contraryto what many are advising investors to do today. I happen tohave learned my lesson when it comes to leverage and I have aspecial place for it in my portfolio. Smart real estate investorsare learning to use leverage wisely and efficiently to put moremoney in their pockets.SURPRISING INVESTORS WITH SOUND ADVICEIn the 4th Quarter of 2012, I made a presentation to a groupof investors in Northern California and I surprised many inthe room when I made a statement that I did not believe youshould buy realestate and leverageit for cash flow.Given that I ama partner in twocompanies thatspecialize in help-ing investors findproperties that pro-vide a positive cashflow after lever-age, this statementcaught much of theaudience by surprise. But I followed that sentence with a bit ofa clarification. I told the group that there are many ways inves-tors can be fooled or even fool themselves today into thinkingthat they are making a positive cash flow on their property. Itold the group that often, the biggest mistakes investors make,is sacrificing long-term stability for short-term gains.THE BANK WINS EVERY TIMEWhen I purchased my first home, I was given one option bythe three different finance companies I visited… a 30-yearSurprising InvestorsWith Sound Adviceon Leverageby Chris Clothier, co-ownerof MemphisInvest.commortgage. The 30-year mortgage has become the staple ofreal estate investing and even Warren Buffet’s recent statementabout the 30-year mortgage shook the real estate world.What many people fail to recall about Warren Buffet’s as-sessment of investing in real estate is that he used the phrase“…if he could…” which, is very different than stating “this iswhat I am doing.” This is worthy of an article all by itself asdifferentinves-tors andinvestmentcompanieshave takenhis shortinterviewand turnedinto thegreatestmarketingpiece they have ever had. His five minute interview has beenused thousands of times already to convince investors thatthey need to mortgage to the hilt all because Warren Buffetmentioned it in his interview. But they all forget two impor-tant points.1. He is one of the wealthiest men on the earth and can af-ford as much leverage as he is comfortable taking on.2. He never says that he is buying single-family PAGE 20 • 2013
  2. 2. He actually lists reasons not to. Now,the mortgage is not one of his reasons,but why would it be? Like I said...heis one of the wealthiest men on earth!The point is that a 30-year mortgagehas become standard and not onlystandard for what companies want toshow, it has become standard for whatinvestors want to see.How Do Investment Compa-nies Show their Numbers?Many companies, who provide invest-ment opportunities, including mine, willshow a mortgage projection based onthe 30-year mortgage.  Why?  Because itis what the average, every day investorwants to see.  It is how we have beenprogramed.  A simple search of theInternet will return article after articleextolling the benefits on using a 30-yearmortgage, especially for the positive ef-fects it has on an investors’ cash flow. When I first started investing, I wascoached to use the 30-year mortgageas a tool to boost my monthly incomewhile allowing a renter to pay down mynote.  When I first started, I loved theidea of using a 30-year mortgage andputting 20% or less down as a GREATtool to boost my cash flow. And it did.It made my cash flow go up and I had acertain level of comfort with that. Theproblem is, unless you have significantreserves in place, heavy leverage cancome back to bite you on investmentproperties.Another major point that I missedwhen I first started investing and hasbeen taught to me over the years fromsome investors much smarter than me,was that for the first 25 years of myownership of that property, I wouldbe paying more in inter-est payments than I wasearning in cash flow.  Inthe first 15 years it would besubstantially more!Own Property Out-right And Reap TheRewardsI am a big proponent ofowning real estate out-right. I have used leveragesparingly over the last fouryears and only as a tool toacquire properties and notas a tool to own properties.I have put every propertythat I have used leverageto purchase on a quickpay off schedule.Many homeowners andreal estate investors willtell you that there is a simplestrategy that makes a 30-yearmortgage a good investment.  Yousimply place a 30-year mortgageon an investment property and pay itoff like it is a 15-year mortgage.  I amneither for nor against this strategy, Ijust do not use it myself for the reasonsI will expand on below. I know as I writethis that there will be some readers whowill comment that yes, this is the precisestrategy that they use and that theycalculate each month exactly how muchmoney to pay to reduce the principleeach month.  They feel that they get alower rate since a 15-year mortgage cancost as much as .25 to a .50 point more. To those readers that follow thisstrategy and actually follow through onthis strategy, I will say that I believe youare in the minority and congratulations! It takestremendousself-disciplineto be able tomake that strategywork and I havemet many investorswho claim this willbe their strategy only tofind that they like braggingabout higher cash flow more thanthey like bragging about owningthe property. The discipline it takes tocarry out this strategy is often missingfrom many investors.Put Your Self In PositionTo Own Your PropertyOutrightAs I stated earlier, the better strategyand the one that I am seeing moreinvestors come around to is usingleverage to purchase properties, butnot necessarily carrying that lever-age for long periods of time. Infact, many investors are choosingto structure deals so that they arepaying off the properties as soonas possible.  Investors taking thisroute are usually financially secureand are not necessarily real estateinvestors.  Often times, they recog-nize the need to diversify into realestate, but are often passive investorslooking for the security and consistentreturn that real estate can give them.They see real estate as a secure invest-ment and rental properties as a productthat will have continued demand in the“...I am seeing more investorscome around to using leverageto purchase properties and cashto hold them long-term.”Continued on pg. 60Surprising Investors with Sound Advice..., pg. PAGE 58 • 2013
  3. 3. Surprising Investors with Sound Advice..., pg. 58foreseeable future. I have a good friend here in Tennessee whois a very successful executive and he has recently made movesto acquire property as he seeks to diversify. When he and I hadlunch, he explained his very reasoning and his absolute distastefor taking on credit risks and leverage.  This is a commontheme among more and more affluent investors looking to di-versify. They are using several different strategies to purchasethe properties.1. They are purchasing properties for cash and holding for aconsistent rate of return recognizing that they can place mini-mal financing against the property in the future to assist withleveraging a larger portfolio.2. They are purchasing property using a 15-year mortgage. They then take the cash flow each month and use it to reducethe principle.  In some cases, this can reduce the term of theloan to less than eight years.3. They are structuring the term of the loan tomatch the monthly note to the rental amountreceived.4. They are purchasing using a mixed bag ofoptions including cash purchases, refinancingexisting properties at low leverage, bundling aportfolio to acquire leverage for new properties.Regardless of the scenario that investors arefollowing, they are using leverage to increasetheir purchasing ability and using the cash flowproduced from each investment property toreduce the principle. The idea behind affluentinvestors purchasing plans are to own the assetsoutright in the shortest amount of time. Thisenables them to keep as much of the return onthe investment as possible.The Single Biggest ExpenseIn A Leveraged PropertyThey recognize that there is only one fixed expense that theinvestor can be in direct control of and that is interest.  Man-agement, taxes and insurance are all fixed costs, which theinvestor has little to no control over.  Vacancy is a variable costthat even with the most prudent management is going to affectan investor at some point and there is nothing an investor cando to prevent.  Routine maintenance and major replacementcosts are also variable costs that, while an investor can preparefor and take steps to reduce, there is still little an investor cando to limit and nothing an investor can do to eliminate thesecosts.  That leaves interest costs as the only major expense thatan investor has control over as it relates to earnings potentialon a property.Many investors that I am talking to today are choosing todo everything possible to reduce the over-all costs of interestincluding choosing higher interest rates to secure shorter termsand buying cash flow properties not for the cash flow, but topurchase more properties faster.  I want to make sure every-one caught that last sentence.  While in San Francisco, thiswas a big point I was trying to get across to the audience andbased on their reaction, it made sense to them.How I Buy PropertiesAs an investor, I believe in buying properties that makesense based on what I have experienced as an investor.  Ihave bought junk properties.  I have bought “cheap” proper-ties.  I have bought properties and done the minimal amountof work to get them “rent ready.”  I have bought propertieswith creative financing such as ARM mortgages and evenbought a couple with interest-only loans.  Every one of thosestrategies was aimed at producing Higher Monthly CashFlow.  And every one of those strategies almost sunk mecompletely as an investor.Today, I buy properties where the fundamental econom-ics make sense.  I told the crowd in San Francisco that whenbuying properties that produce a monthly positive cash flow,they should consider using that money to reduce principle. I cautioned them that if they were attracted to real estateand cash flow because they needed to pay bills, then, in myopinion, they really needed to be positive they were gettingsound financial planning before buying.  I told them that inmy opinion, real estate purchased for buy and hold is a greatway to build and maintain long-term wealth, but a lousy wayto earn short-term money.  I told them that real estate hasthe greatest pay-off when you own it outright and that as aninvestor, getting to that point should be your highest priority. Using leverage to build your long-term portfolio is a greattactic.  Using leverage to build your short-term monthly cashflow is not.Am I off my rocker?  Am I spot on?  Let me know whatyou think…Chris D. Clothier is a Partner at andPremier Property Management Group. He can be reached or PAGE 60 • 2013