Many physicians and dentists have turned to real estate—and for good reason but unfortunately, many believe there’s only one way to buy real estate. They believe they need to take their existing cash from somewhere else or save the necessary funds so they can do the down payment needed to buy the property. This belief forces them to consider how they currently have money invested and then they ask themselves a series of questions to determine if they believe investing their money in mutual funds, bonds, etc… is providing a better return than the rate of return they could receive if investing that money in real estate. Many then come to the conclusion that they feel they could make more money investing in real estate and they cash out of investments or use a pile of cash to buy the property. Most believe the money can only be invested in one place. It’s either invested in an account, or it’s not and it’s invested in a property. That thought process or logic leads you to believe that you must choose one because you have one dollar and it can’t be in two places at one time. Today I want to help you think outside of the box many are in as I mentioned above. What if you could leave your money invested, benefit from long-term market returns, tax-deferred growth, and still use that money to buy property?
1. Assets as collateral
Banks are willing to use property, taxable brokerage accounts, cash values of a life insurance policy, CD’s, and other accessible assets as collateral. For this article, I will use brokerage accounts as an example.
In return for your collateral, banks will supply you with a secured line of credit equal to roughly 70% - 85% of your brokerage account. They will lend this money to you because this is considered a secured debt. The asset you’re assigning is worth more than the loan they’re giving you, so the bank knows they can easily clear the loan if needed, which is why they’re comfortable lending a large amount at a low-interest rate. For example, if you default on your mortgage payment, the bank can take your home because the home itself is the assigned collateral. When you buy a home with a mortgage, you assign the rights of ownership to the bank, which is why they’re willing to give you such a large loan at such a low-interest rate.
Similar to the way one would procure a mortgage with the home serving as the assigned collateral, the bank will also allow you to use an investment account to secure a line of credit. The bank will only lend up to 70% - 85% of the value in your brokerage account because they know the balance will fluctuate with the market. The bank isn’t concerned with the account growing but they are concerned if it drops in value. The bank requires you to maintain the loan to value that was initially approved. If the bank approves that you can borrow up to 70% of the $100 you have in a brokerage account and the market drops 50%, cutting that balance in half, the bank will require you to add $50 dollars to the brokerage account so the loan balance of $70 is equal to 70% of the account’s value. Therefore, we encourage everyone to consider market fluctuations, as well as their liquidity needs, prior to drawing money from a line of credit for any reason. If you intend to borrow the full amount, you should always have liquidity elsewhere that can be used to replenish the account if a market correction occurs.
2. The opportunity cost of using your cash
At this point you may be asking, why should I borrow against my brokerage account if I wish to buy a business or property? Why would I not cash out of the brokerage account investments and use the cash to buy it? Rather than cash out of my investments to purchase the property, which would require me to pay taxes on capital gains and prevent further returns in the market, I can take a loan against those assets at the prime rate and let my brokerage account continue to grow.
I can then use the loan as a down payment on an income-producing property. Once the down payment is made, the property itself serves as the collateral for the remaining 80% to 85% that needs to be financed (depending on the terms you negotiate with the bank), just like a normal home purchase. The income generated from the property needs to be enough to pay the interest on the line of credit used to facilitate the down payment, service the property’s expenses, taxes, mortgage payments, cleaning fees, etc.
Rather than utilizing the net income created by the property as additional income today, you would use the income to repay the line of credit balance or you would add the net income to your brokerage account. If you pay down the line of credit with the net income, then you are increasing your borrowing capacity and avoiding interest. If you add the net income to your brokerage account, you’re increasing your borrowing capacity and earning interest. Both are good options. The latter would be better than the former if the earning rate is higher than the interest rate, which is a little hard to predict with a floating prime rate on the debt and a fluctuating market.
There will be some that are comfortable with investing the additional income because they expect the earning rate will be greater than the prime rate, and there will be others that don’t like carrying a large amount of debt and prefer to use the net income to repay the line of credit as quickly as possible. Either way is fine but the point is this, the income created by the property pays back the line of credit and mortgage of the investment property over time; therefore, you are receiving three forms of return, all of which are generated by utilizing the brokerage account as collateral.
The first is the return generated by the brokerage account
The second is the net income created after all expenses are paid, which can be invested in the brokerage account or used to repay the principal of the line of credit. Once the income produced by the property exceeds the amount of the initial down payment, it could then be used to make additional principal payments on the mortgage, spent, or invested.
The third is equity in the property. The mortgage of the investment property is being paid by the income the property earns. After 20 or 25 years, depending on the amortization length you choose with your bank, the property will be paid off.
3. Tax Advantages
As I’ve mentioned here, there are several tax benefits that come with investing in real estate. I won’t cover all of those in this article, but there are two pieces to this that are important when considering the use of this method in your own financial planning.
Depreciation schedules for the real estate structure, furniture, equipment, and so on that are included in the purchase allow you to show a loss against the income earned. The loss is subtracted from the income and you pay income taxes on the difference. A good portion of the income earned will not be taxable when received because of the way depreciation schedules work, which means some of the distributions you’re taking to repay the line of credit, invest in the brokerage account, or even use as additional income may not be taxed as income today. Now, when you sell the property, you are required to pay a maximum tax rate of 25% on the recaptured depreciation; however, this tax can easily be deferred by selling the home and performing a 1031 exchange.
A 1031 exchange allows you to defer the tax on capital gains and recaptured depreciation when you sell a property by allowing you to use the proceeds from the sale, by way of an escrow account and 1031 intermediary, to buy a like-kind property. Doing so gives you more purchasing power for the next project and allows you to increase your passive income over time. Eventually, the tax will come due on all of the recaptured depreciation and capital gains, but only if you sell the properties without doing a 1031 exchange during your lifetime. If you own the property in your name when you pass away, your heirs receive a step-up in basis, which is based on the fair market value of the property on the day of death. This effectively wipes out the taxes you would have paid if you sold the properties without a 1031 exchange during your lifetime.
4. The risk
If you always use cash to purchase real estate, you are paying interest in the form of lost returns over time. Investing the cash in the property doesn’t provide any additional growth in the years to come. If the home appreciates in value, I benefit from that growth whether the down payment was made with a line of credit from the bank or with my own money. Using my cash would avoid the interest on the line of credit, so then the question to ask is, do you believe the investments of the brokerage account and tax benefits of using this method will generate a higher return than the interest rate of the loan over time. If the answer to that question is yes, then the spread between the earning rate of the collateral and the borrowing rate on the line of credit, compounded over time, equals the opportunity cost for the person choosing to buy a property with their own cash. The risk with this method and where it loses its’ value is if the return of the collateral investments is not greater than the cost of borrowing. If we have a market correction and the bank tells me I need to add money to the brokerage account because the loan is not equal to 70% of the account’s value - that’s fine with me. The bank is just forcing me to buy in when the markets low.
As I stated earlier, you must always assess your liquidity needs and have plenty of funds available in other places so you can easily add money to this account if needed during a market correction. As long as you maintain plenty of liquidity, it’s not the worst thing in the world if the bank requires you to add money to your investment portfolio during market corrections. In fact, it could actually be a really good thing. The concern would come if I don’t have the liquidity to add money during market recessions or if the returns end up being lower than the borrowing rate over time. However, let’s assess the consequence or risk of using this method compared to someone using their own cash to do the down payment. If you had $100,000 in a brokerage account and the market falls 20%, you would have $80,000 in the account. Let’s assume you borrowed 60% of the account value and the bank will allow you to borrow up to 80% in this example. A loan of $60,000 is still less than 80% of $80,000, so the bank wouldn’t require any additional capital. If markets went down further as they did in 2008-2009 to where you suffered a 40% loss, then the bank would ask you to put in $15,000 in the account in order to get the account value to $75,000, which would bring the loan back to 80% of the account value ($60,000). If you didn’t have the $15,000, then you could cash out of the brokerage account and clear the line of credit.
The primary goal of this article is to help you think through opportunity cost, the tax consequences, and optimal use of capital when investing in real estate. You can certainly cash out of investments in the market or use cash on hand to cover the necessary down payment, but consider the use of collateral as I believe it provides a unique method that could enhance your long-term net worth over time.
*Past results do not guarantee future outcomes.
