Should I own my rental property free and clear?

Everyone knows that investing in rental properties can be a great way to grow and preserve wealth, and that there are many different strategies to building a rental property portfolio.

Whether you’re thinking of buying your first rental property or a starter home that you will eventually rent out, or are already well on your way to becoming a property magnate, your ultimate goal is probably to own your rental properties free and clear, am I right?

And this ultimate goal is irrespective of your strategy, whether you’re part of the “I don’t like debt so I buy all cash” crowd or if you subscribe to the “no money down”, use Other People’s Money doctrine.

It’s always the ultimate goal. I always hear it. “Once I have X number of properties, I will pay them off and live off those sweet monthly rent checks”.

In this post I challenge this notion.

After briefly going over the advantages and disadvantages of owning rental property free and clear, I will attempt to demonstrate why you may need to start looking at owning rental properties from a different perspective. 

I will also provide you with practical insights to help you in your decision-making.

And with that said, let’s dive right in.

Advantages of owning rental property free and clear

There are two main advantages to owning rental property free and clear. Let’s quickly go over them to make sure we’re all on the same page.

The first one, is that you’ll make more cash-flow from a property that you own free and clear versus having a mortgage on that same property.

No mortgage payments equals more cash in your pocket every month. It’s as simple as that.

The second advantage, and not unrelated to the first, is that you’ll have more piece of mind.

You’re free of the obligation of a mortgage payment and you have untapped equity that you can always access should you come into financial difficulties or need a substantial amount of cash for whatever reason.

Either by selling your property or borrowing against it. 

And by definition, you can never be underwater on your mortgage (whereby you owe more to the bank than the property is worth) or be foreclosed on.

Now let’s move on to the disadvantages.

Disadvantages of owning rental property free and clear

The main disadvantage of owning rental property free and clear is that you’ll be making lower returns on equity than you potentially could be, since you won’t be benefiting from leverage. This is especially true in an environment of low interest rates and rising property prices.

Another way to look at it is in terms of opportunity cost. You are giving up the opportunity of leverage that could allow you to control more properties for the same amount of equity/cash.

There are of course other opportunity costs, could you get better risk-adjusted returns by building an income portfolio made up of any of the 7 best types of income investments? 

Or putting it all on the next Tesla (I’m only kidding).

The other main disadvantage of owning rental property free and clear is that you’ll probably be paying more in taxes since you will not able to deduct interest payments from your rental income.

Of course this will depend on your personal situation but in many parts of the world this will be the case.

How to decide if owning rental property free and clear is right for you

Now that you have an overview of the advantages and disadvantages, let’s put it all into perspective. Is owning rental property free and clear right for you?

Well, as is the typical answer to most financial questions, it depends.

To help you answer the question for yourself, you need to look at rental property in the context of your financial goals and your current situation.

There’s no two ways about it. Rental property investing should be considered a means to an end and not the ultimate goal in and of itself.

Once you’ve got a good grasp on what you want to achieve, it then becomes much easier to decide whether owning rental property free and clear is right for you.

Let’s now go over some key considerations to help you make your choice.

Maximizing returns

If you’re looking to maximize returns from your existing rental property, whether it’s because you’re still early in the accumulation phase of your life or because you’re still behind on your ambitious “becoming a millionaire” goals, then you need to look at owning rental property free and clear from a return perspective.

Essentially, when you own property free and clear, you are saving money by not paying interest. So to maximize your returns you need to compare the interest rate on your mortgage with returns you could get elsewhere.

If your mortgage rate is relatively low and you are confident (and capable of investing in assets that would result in a return above your mortgage rate (e.g. dividend stocks, Real Estate Investment Trusts, bonds, etc.), then you will improve your returns by not owning your rental property free and clear.

This of course, even applies to buying more rental properties. If real estate prices continue to rise for the foreseeable future, the best decision is always to use the money to acquire more quality rental properties, with leverage, versus using the money to pay down the rental property you already have.  

If you’re not confident of being able to generate returns that are greater than your interest rate, especially if your mortgage rates are relatively high (e.g. in times of high interest rates), then striving to own a rental property free and clear would be the right decision in terms of maximizing returns.

You would get a guaranteed return equivalent to your mortgage interest rate.

It is important to note here that you should consider the tax benefits of interest deductions in all your calculations and that you should be conservative in all your investment return assumptions.

Capital preservation

On the other side of the spectrum, we have capital preservation or, more generally, safety and peace of mind.

For example, if you’ve already accumulated enough capital, are close to attaining your financial objectives or are nearing an acceptably comfortable retirement, then you’re much more likely to be looking to preserve your capital and consolidate your assets.

In these scenarios, accelerating your mortgage repayments, selling a few rental properties to pay off the rest of your portfolio, or investing in “all cash” rental property deals to supplement your income starts making a lot more sense.

You have “enough”, are satisfied with what you’ve achieved and are not striving for more, especially if this would risk what you are already have. After all:

“Rational people don’t risk what they have and need for what they don’t have and don’t need” Warren Buffett.

If the above applies to you then owning your rental property free and clear would be a perfectly reasonable choice.

Diversification

You already know that diversification is incredibly important when it comes to investing.

Unfortunately however, when it comes to rental properties, many real estate investors focus exclusively on growing and maintaining their real estate portfolios, most likely concentrated in one country or even a single town or city.

Make no mistake, I’m not here to tell you to diversify away from what you’re good at.

After all investing in real estate can be a very wise choice, and a great vehicle to accumulate wealth if you successfully and prudently use leverage.

Though do make sure you’re aware of the risks and can survive a substantial downturn in the real estate market or a rise in interest rates.

But what happens when you’ve already “made it” so to speak, you’ve accumulated a substantial portion of your wealth in equity in rental properties, or you already own your rental property free and clear. What happens then?

This where I want to emphasize diversification. Because in this scenario, you’re no longer benefiting from leverage (so you’re not maximizing returns) and you could be over exposed to local real estate (so you’re not optimizing capital preservation either).

Let’s take a concrete example, let’s say you have reached your objective of financial independence by owning a portfolio of 5 rental properties free and clear, you also own your personal residence and have cash in a decent sized emergency fund. Your pension will start coming in at some point too.

Congratulations! Sincerely.

But wouldn’t it be more prudent and diversified, to sell one, two or three of your properties and invest in the financial markets for at least a similar yield, while freeing yourself of the hassle managing rentals?

What about investing part of it in a portfolio of Real Estate Investment Trusts, which are themselves diversified, focusing on those with an excellent record of dividend growth and a similar yield as your current rental property portfolio?

You get to maintain exposure to leverage through the REITs’ leverage (quality REITs usually employ around 30 to 50% leverage). And your REITs will take care of tenants, property maintenance and growth for you.  

There’s another alternative, what about trying to re-obtain a mortgage on one of your properties and investing the proceeds with a view of increasing diversification elsewhere?

You can do it in a way that will make it very easy for you make the mortgage payments and maintain some exposure to the benefits of leverage. It’s definitely an option at the very least.

And with that said, it’s time to conclude.

Do you see now how owning rental property portfolio free and clear is not an end goal in and of its self?

While eventually you should target to own some of your rental properties free and clear, it’s important to understand that paying off your mortgages may come at the cost of building more wealth.

If your wealth is mostly concentrated in free and clear rental properties, then you should definitely consider reducing your exposure and diversify into other investments types.

This will help you preserve your capital and potentially even increase your returns.

So just because you may be a good real estate investor, it doesn’t mean that you shouldn’t educate yourself on the financial markets more broadly.

After all, as we’ve seen, there will come a point where the right decision will be to diversify and invest in other assets, while still owning some rental property free and clear.