Leverage or Cash Purchase? The Pros and Cons Explained

The accepted wisdom is that the more you leverage (borrow) to purchase property, the better the returns. I would generally agree with this, to the extent that for many clients I have even recommended doing low money down deals if they are achievable.

However, getting stuck in this way of thinking can be a big mistake. Every investor needs to weight up the benefits and drawbacks of borrowing very carefully. Let's ask ourselves when it might be appropriate to pay cash for a property?

Established wisdom is to borrow

Most clients who borrow extensively do so because cash is a scarce resource. Let's say you have £100,000 in capital available. This is hardly enough to buy one modest apartment in the UK for cash, but possibly enough to purchase four apartments assuming 75% lending.

The difference between these two approaches ten years down the road, are considerable. Let's say your property has doubled in value.

In the 'all cash' approach you now have an asset worth £200,000. Your profit is £100,000 - that's the growth in value over ten years and your unrealised profit.

But if you borrowed and now held four properties, then your assets would be worth £800,000, of which you would have borrowed £400,000. So your unrealised profit is now £400,000.

Clearly from a capital profit perspective we would all prefer to have four properties instead of one.

So let's look carefully at six situations where it may pay you to use cash!

You have, or can get access to, plenty of cash

Suppose you are flush with cash and much of it is invested at low rates of interest. Borrowing is likely to cost you considerably more than the loss of savings interest. So what's the point of borrowing at higher rates when you could use your cash and get a better return?

In the previous example, if you had the cash, why not buy all four properties outright? This would not impact the capital profit (which would remain the same), but it would massively increase your net income during the process and remove all financing risks.

So clients with plenty of cash should make the decision about using it in a simple way - if you get a better return (income or capital growth or both) through property, better to place it there!

You are investing for income

Borrowing high percentages of the property value will decimate the net income you receive. In fact, it can turn a positive cash flow into a negative one if you are not careful.

So, if you are investing for income generation the simple rule is to borrow as little as possible and maximise the net income you receive. When Axis offers rental properties that can return up to 20% net pa, this is not a difficult decision to make.

When velocity more than makes up for lack of leverage

I don't hear other property commentators talking about 'velocity', but to me it's a critical part of understanding how property performs and how to finance your investment.

Velocity is the speed of growth that happens when you purchase property.

Here's a question for you. What's better from these two options?

Option One: Buy a property with 70% borrowing that grows at 4% a year, or

Option Two: Buy a property with no borrowing (all cash) that grows at 20% a year? Clearly this property is demonstrating excellent velocity but is it enough to overcome the lack of finance?

Let's take a view over three years, assuming a property price of £100,000.

The clear winner is Option Two - paying cash. I chose examples which show a big difference in favour of velocity to illustrate the point. We get so fixated on borrowing that we forget to choose the right investment – one which delivers quick growth and, for this, you can do far better by paying cash.

Here's a very pertinent example that's true in real life now. Property growth in the UK is questionable over the next few years - in fact it may be relatively negligible. If that is what happens, borrowing heavily to finance property is the worst option - you lose most of your rental income but you don't benefit from capital growth.

Contrast this with the USA, where the incredibly low prices are offering potentially strong growth over the next 3-5 years in states such as Florida. Paying 100% cash there, for investors seeking capital growth, could be a very wise move.

When borrowing is not an option

For virtually all properties in the USA right now, borrowing is not an option. So there is not a question of should you borrow or not. The simple fact is that if you want these amazing deals, you'll have to pay cash. In fact it is your ability to pay cash that is making the incredibly low prices achievable.

When you purchase a foreclosure from a bank, the bank wants the cash back. They are not interested in lending you the money to buy a dirt cheap property they have just lost money on. Why? Because the property is worth less than the loan they had given to the previous owner!

When you make a short term investment (flipping, in USA language)

Our investment property in Memphis enables clients to buy and resell for a good profit in around a 12 month period. This is a popular strategy in a market which is primarily focused on a buy and hold model.

Because of the short-term nature of the investment, any finance would be prohibitively expensive. You would be paying arrangement fees, high interest rates and exit fees, even should finance be available. This would remove much of the profit from the deal and swing it from being a great deal to one that is marginal.

As such, paying cash is the smart option, leaving all the profit in your pocket.

When the property price is incredibly low

Our USA properties start at around $25,000 (around £15,500). To be frank, lenders aren't interested in lending these amounts because the paperwork, processing and due diligence eats up the little profit, even at very high rates of interest. At these prices investors are better off tucking their investment property away and just enjoying the high levels of income.

These six scenarios show clearly that the decision about whether to borrow is not all one way, and that careful consideration should be given to paying either all or mostly in cash in many different situations.

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Posted in Investment Strategies