We previously discussed how much cash someone might need in order to buy a rental property and that got me to thinking about a question many real estate investors are faced with when making a purchase decision: Cash or finance?
For many of us it isn’t even an option. We have to finance because we don’t have enough cash to purchase a property outright. But what if we did have $150,000 in liquid assets? Would it make more sense to put it all on one house or break it up and buy two or three properties?
A cash buyer with a $150,000 spending limit could only buy one single family house in Central Oregon. With that one house, a real estate investor could reasonably expect $1100/month in rent income less $40/month for homeowner’s insurance and $145/month for property taxes. That translates to 7.3 percent return on cash investment in a year. Assuming an average annual appreciation in the value of the house at 3 percent a year, total return on cash would be 10.3 percent/year.
Instead of buying one house with that $150,000, lets say our investor chose to buy three $150,000 houses with 25 percent down.* Down payment plus 3% for closing costs would equal $42,000 cash to close for each house or $126,000 for all three houses. The principal and interest payment would be $621.23 (@ 5.25%) and if we add homeowner’s insurance ($40/month) and property taxes ($145/month) the total monthly payment for each house would be $806.
Assuming that each house would rent for $1100 a month our investor would have positive cash flow each month of $882 or 7 percent return on cash each year (total for all three houses). That number, compared to the return of the all cash purchase is lacking just a bit but then we haven’t factored in appreciation yet. If we again assume that each house will appreciate 3 percent/year, the return on cash invested jumps up to 16 percent.
A better return on cash invested isn’t the only benefit our real estate investor gets by financing three houses. Money is still at historically cheap levels. If you think mortgage interest rates will go back below 4% in the next five years please raise your hand. If you raised your hand you are either an eternal optimist or you don’t keep up with current events. Borrowing money now is a great hedge against rising interest rates. Do you think our investor would rather borrow money now at 5.5 percent or later at 7.5 percent?
Financing rental properties isn’t just a hedge against rising interest rates but it also serves to shift some of the risk to the lender. Whether our investor chooses to invest in one $150,000 rental property or three, the risk to the investor who borrows money is as low as $42,000 per property financed compared to $150,000 for a cash purchase in this example.
The thing is, some people don’t look at risk that way. Some real estate investors want nothing to do with a bank or financing and would feel much more comfortable knowing that their investment is 100% paid for. Investing can be as much about being comfortable with where and how your money is invested as it can be about making money. What is important is that you understand the options available and how those options might affect your ability to sleep at night.
*It is possible to buy a rental house with only 20 percent down (conventional financing) but for the purposes of this post we are using the more common requirement of 25 percent down payment.
