Your plan of investing sequentially - selling one property to buy the next, using a 1031 tax deferred exchange - is by far the more prudent of the two options you present. Financing the current property (cash out) to purchase the second is the more adventurous for sure and should only be done after a very careful and realistic consideration of both properties’ appreciation and rental prospects.
With the financing option, you are leveraging your investment and, as such, both your potential upside and downside are magnified. Specifically, I presume the modest positive cash flow you are earning now from property 1 would turn negative when new debt service is included. Will the second property generate enough positive cash flow to cover this shortfall? And if not, do you have sufficient cash on hand, or a positive personal cash flow, to support any resulting negative cash flow?
Are you counting adequately in your income and expense projections for vacancies? Maintenance reserves? What would happen if one or more of the rental units stayed vacant for 3 months, 6 months, or more? These are not necessarily catastrophic when you own a property that is not indebted, but can become so if you have a monthly mortgage payment to cover out of pocket.
Leverage can be a great way to speed up wealth accumulation in real estate, when it is used intelligently. However, it is also a blade that cuts both ways and many investors have found out the hard way that when rental income falls, so does the value of the property, meaning you may have to sell at just the wrong time if you cannot keep servicing the debt during a downturn.
Make sure you know what you are doing, and have done a thorough financial analysis, before proceeding. Most commercial RE brokers should be able to assist with the latter.