June 14, 2012

Should You Finance a Rental or Pay Cash?

As I've mentioned in the past we own a few rentals.   Two of them are owned outright with no mortgage and the other two we have mortgages on.   We bought the two rentals with cash because they were distressed fixer upper  properties that were in poor condition and you'd have a harder time getting financing on.   The other two rentals with mortgages used to be my wife's primary residences and she kept them as rentals as investments.

Whether its better to pay all cash or to finance the rental investment depends on the situation.    Theres no 'one size fits all' correct way to go.

Lets look at some examples:  

You're thinking of buying a duplex for $100,000.   It rents for $500 each side for $1000 total rent.  Lets assume that you have 95% occupancy, annual repairs and maintenance of $1000, property tax and insurance totaling $2000 and you pay the water and garbage for another $750.  

That gives you rental income : $11,400
Expenses  = $3750
Net $7650

If you paid cash with $100,000 total then you'd be getting about 7.65% return on your investment.

If you financed the property with 30% down and got a mortgage for the remaining $70,000 then your mortgage payment would be about $350 per month or $4200.

So with a $30,000 cash investment you'd be netting $3450 which is a 11.5% return on your down payment.

Option 1 : Pay cash 100%.  Invest $100,000 and get $7650 /yr = 7.65% return
Option 2 : Finance with 30% down.  Invest $30,000 and net $3450 /yr = 11.5% return

In this example financing the rental would be a better overall investment since it gives you higher return on your investment.  

Now of course if interest rates on the mortgage were significantly higher then financing would start to be a poor option.

Lets run the numbers again but assume a 7% mortgage rate on the rental investment.

With 7% loan your payments would be $465 a month or $5580 a year.   That would give you a net of $2,070.   Thats a 6.9% return on your money.

What if your expenses are higher?    Lets say the property taxes, repairs and utilities are $2000 more and add up to $5750.   In that case you'd have lower cash flow in either case, but it would almost eliminate your cash flow with the financed purchase : 

All cash purchase $100,000 = net $5650 = 5.655% return
30% down payment $30,000 @ 4.5% loan  = net $450 = 1.5%

The lower the interest rate, the more appealing financing can be.
The higher the cash flow the easier it is to make a good return with a financed property.

There are other pros and cons to paying all cash versus financing.

Financing :
PRO: Its much easier to accumulate cash for a down payment rather than pile up enough money to buy a property outright.
CON : There is a lower margin of error for a financed property.  If you have a major $5000 repair on the property one year then that could easily eat up all your cash flow.

All Cash 
PRO : Paying all cash saves you on financing costs since you don't have to pay for closing fees on the loan.
PRO : Allows you to buy some properties that won't qualify for financing. 
CON : Sinks all your cash into an illiquid investment.

Leveraging has risks and rewards 

When you finance the property you are leveraging your investment.   This will have a significant impact if the property appreciates.  Lets say for example sake that in 10 years your property goes up from $1000,000 to $150,000 or +50%.   Thats a reasonable long term appreciation rate for real estate of around 4.1% annual growth.
If you pay all cash then you get a 50% return on that appreciation.  Thats pretty good.    However if you financed the property with 30% down then your $30,000 of initial equity now amounts to $80,000 equity.   Thats a 166% return on your money which is great.   If you get healthy appreciation then leveraging the property will give you a much better return on the investment. 

Of course we should all be aware due to the recent real estate collapse that properties do not always go up in value.  Say you bought this investment back in 2006 at the height of the real estate bubble.  It would not be unusual for you to  be underwater on the investment at this point by 20-30%.   Lets say you paid  $100,000 in 2006 and today its only worth $75,000.   If you paid cash you'd have lost 25%.  If you financed with 30% down then you'd have lost 83%.

Leverge is a two edged sword.    With 100% cash purchase you're a lot safer but you miss out on the great return on investment from appreciation.   When you finance you're hoping for some good appreciation and you can cash in a large return if you get it, but if things go bad you can lose all your money or worse. 

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