Should You Borrow Money to Invest in Real Estate?
December 28 2016 Posted by Guriqbal Chahal, MBA, PMP
There's no disputing that real estate investment is one of the best business models for those looking to achieve long-term financial success. The one problem most would-be investors have, however, is the fact that real estate is a business with a high capital requirement. This leads many to borrow money to finance their real estate investments, a factor that can worry more conservative potential investors. So, should you use borrowed money to finance your first few real estate deals?
The Upside of Borrowing Money
Borrowing money for property is a common practice among real estate investors, even those who could probably finance all of their deals themselves. Borrowed money has the advantage of not coming out of pocket and not tying up massive amounts of your capital. Even for a successful real estate investor, tying up $100,000 or more in a property can be difficult for cash flow. Extrapolate that over the several deals that seasoned real estate investors may have going at any one time, and it is easy to see why borrowing money is a common practice.
The Risks of Using Borrowed Money
Of course, borrowed money also has its risks. Using borrowed money means that if a deal becomes unprofitable, there will still be repayment, not to mention interest, to deal with on top of the losses. Relying too heavily on borrowed money also makes your real estate investment business too reliant on banks or other lenders, preventing you from achieving financial autonomy in your business. This lack of autonomy can also lead into another problem, which is that banks are often wary of lending to real estate investors as opposed to actual home buyers. There are other sources of money, such as hard money lenders, but most beginning investors will not have access to those opportunities. Relying on a bank to lend you the money for your business may ultimately limit your business more than expand it.
Is Borrowing a Good Option for a First Investment?
As strange as it sounds, it is better to buy your first investment property with cash and then scale your business by borrowing money later on. However, this path will only be open to those who have the means to buy a property outright. For everyone else, borrowing will be a reality, regardless of whether or not it is optimal. If you need to borrow money for your first real estate investment, there are some things you can do to limit your risk. Firstly, start by investing in a property with a relatively low buy cost, so as to limit the amount of money you have to borrow. You should also be sure to find a deal that you are sure can turn you a profit, as losing on your first real estate deal while using borrowed money can all but put you out of business. Finally, only borrow what you need. If you can fund a portion of your investment yourself and only borrow part of what you need, you will find yourself paying interest on a smaller principal amount.
When is Borrowing the Better Option?
Although cash may always seem better, there are some circumstances wherein borrowing money is clearly preferable to using your own money. The best example of one of these scenarios is when buying a property to turn into a rental. Unlike a flipping deal, you will not make your money back on a rental property for years after the purchase is made. With that said, it makes little sense to invest your own money into a rental property unless you have so much capital that you can afford to have your money tied up for years or even more than a decade. A better approach for most investors is to borrow against the house and rent it out at an amount that produces a positive cash flow, thus generating some income and building equity in the house as it is paid off.
Another instance in which it makes sense to borrow for real estate investment is when an investor is buying a house or property at a higher price than what he or she normally deals with. Higher-priced properties require a larger initial investment but can also yield much higher returns than their low-price counterparts. Borrowing a portion of the price of a high-value property can be sensible, as it allows you to expand your established real estate business into increasingly larger deals.
Borrowed money is an integral part of the real estate business, but it does need to be approached with a proper respect for the risk that comes with it. For those who have enough capital to buy properties without damaging their own financial well-being, it is best to do so under most circumstances. However, for the majority of real estate investors, borrowing money to finance properties is necessary to some degree. If you do need to borrow money to finance a property purchase, be sure to invest in a property you know can turn a profit, and use the money you borrow wisely in order to prevent substantial financial risk.