Buying Rental Property: Should you Pay Cash or Get a Loan?

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  • Hi Mark,

    Thank you for the great article! I really appreciate your method. I am looking to get started buying properties and renting them as long term investments. I find it hard to do so in the location that I am, currently (Burlington, VT) due to high prices of properties. I was wondering if you wouldn’t mind sharing a bit of where you are buying these rentals.

    Thanks,
    Manny

    • investfourmore says:

      I am in Northern Colorado. The market has gone up a lot here in the last year. The deals are definitely harder to come by, but out there if you look hard enough.

      • Thanks Mark!

    • Some investors are concerned about the leverage model, especially in light of the real estate meltdown of 2007 and beyond. Many people simply couldn’t deleverage fast enough. Since 1973 when i first became a Realtor, buying sfr’s as rentals was generally a wise move depending on the deal, of course. My investor clients, all high net worth folks pay cash up to $750,000 for a well-located and good home, content with as little as 3% cash-on-cash return knowing that some of these properties will likely sell for double the current price (about was they cost at the highest part of our market. Frankly, I was surprised by this approach but see a good bit of solid wisdom.

      • Hi Tom, How are you!
        Thank you for the comment. I would agree for some high net worth individuals that do not have other outlets for their money, paying cash for property makes sense. For those looking to build wealth quickly I think leverage is the way to go, as long as you follow your guidelines and buy for cash flow.

        • Nightvid Cole says:

          Cash flow should be roughly irrelevant though. I realize some assumptions behind the Modigliani-Miller theorem aren’t quite true, but it’s still a useful result in economic theory because it forces you to question your assumptions.

          Modern economics takes this theorem to be an important result, and I’ve yet to get a clear explanation on which deviations from the theorem’s assumptions should prevent it from even *approximately* applying in real estate.

          • Cash flow is what you make every month from your investment. If you are only investing for appreciation you are basically speculating that prices will go up. Are you saying you think 20 percent return on my investment is irrelevant? That doesn’t make much sense.

            The model you discuss says the difference between bank financing and say a stock sale should be irrelevant to the value of a company. Not that bank financing is not relevant versus an all cash strategy. Almost all companies use stock sales or bank financing to increase returns.

  • Mark,

    I’ve purchased properties both ways – cash and financing (FHA and conventional), and I think there are two potential benefits of paying cash for properties not mentioned above. 1) for certain distressed properties, I believe you gain an advantage in the bidding process by being a cash buyer. I’ve witnessed this in both a short sale situation and an REO, where I was able to purchase properties for $5K-$10K below other offers. 2) some properties that require a sizable amount of rehab may not be eligible for financing. In Texas, many distressed homes have foundation problems, and require $3K-$7K in repairs. I’ve found lenders shy away from properties that require this kind of major repair.

    My workaround is – pay cash, and then do a cash out refinance six months down the road, after the property is rehabbed and rented out. I’ve done this twice and was able to borrow 70% of APPRAISED value (not 70% of my basis), which in my case allowed me to borrow 100%+ of my investment in the property. One caveat though – you can’t do this if you’ve placed the property in an LLC.

    My $0.02. I still agree that – in most situations – borrow as much money as you can at these rates and allow leverage to work in your favor.

    Jason

    • investfourmore says:

      Thank you for the comment Jason! Great information. Cash can sometimes get you a better deal on an REO. My lender does not care about repairs and I make sure I let the other agents involved know that. All my lender wants is an appraisal if the purchase price is over 100k.
      My lender does not care about the properties being in LLCs either as I just did a cash out refi this year. I have heard from many other people, that most lenders do not like properties being in LLCs.
      That is great that you can refi with a new basis after 6 months. My lender makes me wait a year, like most.

      • Connie Smith says:

        I’m in Az, have properties in llc. Would love to talk with your lender!

    • Jason,

      I thought cash out refinance is not allowed in Texas. A lender told me that when I did a refinance with them. The closing cost can be included in the loan, but they are not allowed to write me a large check at the end. I had about 50% LTV when I refinanced.
      I also googled on the topic of how to get a loan when a house is already paid off. The only choice seemed to be home equity loans.
      How did you refinance?

      John

  • Kevin Wall says:

    I am using the same approach and like it. Leverage is key as long as you have enough cash flow not to have a alligator
    that eats you.

  • James Brandt says:

    If you feel that leveraging your money is the way to go then why pay off the loans so quickly? (waterfall effect)

    • For a number of reasons.
      1. when you have more than 10 mortgages it gets much harder to leverage and finance properties.
      2. My loans are ARMs and the rates can adjust after 5 years to a higher rate
      3. Having paid off properties gives me more financing options like lines of credit.

      If I could get as many 30 year fixed rate loans as I wanted and I knew that would never change, I wouldn’t pay them off.

  • James Brandt says:

    I recently sold a company and have plenty of cash flow. Purchased a one family for $55,000 cash and renting it for $750. Like my return but now thinking I could have an even better return if I had financed it. Looking for other similiar properties and wondering if I should be financing even though I have plenty of cash? You have given me a lot to think about.

    • I personally would finance them, but it all depends on your level of comfort with debt.

  • Vincent A Saint says:

    Hello, I am in the process in buying an investment property in Florida and am using funds from a line of credit on my primary residence as a down payment. I like the leverage method for all of the reasons that you mentioned before but also for the tax deduction/ expense that you get to take at the end of the year. If you pay cash then your entire rent roll becomes profit,therefore 100% taxable. If you have a mortgage you get to deduct the interest that you are paying on the loan.

  • Nice article. How does the guideline some lenders follow with not lending where you have more than 4 mortgaged properties. It would seem that to these lenders, once you have 4 mortgaged properties, you cannot obtain any more financed properties, thereby limiting future investment purchases to cash purchases. What do you recommend?

    • There are many ways to get more than four mortgages. Find a portfolio lender or some conventional lenders will lend on more than four. Don’t believe the lender that says you can’t get anymore than four mortgages.

      • Fennie Mae guidelines allow upto 10 loans on each individual names. After 10 it becomes little difficult. Once you have 10, then you have to find the portfolio lender, also known as private lenders. The major problem is….. with portfolio lenders, the interest rates are 6% – 9%

        • Mark Ferguson says:

          Hi Parry, Portfolio lenders are different than private lenders. Banks that lend their own money and do not sell loans on the secondary market are known as portfolilo lenders. Private lenders are anyone with money that will lend it to you. You can also get lower rates with the right portfolio lender.

  • Hi Mark, I have 100K to invest on rental property and was thinking to put all for one property. but after reading I think i shouldn’t put all my 100k in one property. My job is to move to other place every one or two year. What you advice me here. Thanks Ashok

  • Hey Mark, I think I will have enough money to put 20% down on my first house, but it will be awhile before I can save up enough to put 20% down on another home. I am in a very good location for renting and project to get between $1,100-1,500 on a 100-130k property. after accounting 10-15% for maintenance, and 10-15% for vacancies, I should still see about $400-500 monthly cash flow. My question is if I should move forward getting a second house when I can only put down 10% on the home? I will have a PMI payment of about $80-100 per month if I do so. This would still leave me with a positive cash flow, but the margin is definitely slimmer.
    I’d just like to know your thoughts.

    Thanks

    • Mark Ferguson says:

      I think that depends on how long it takes to save up for a down payment, if you can get the PMI removed and many factors.

  • Mark,
    Why would you focus on paying the mortgages off with the cash flow versus using that cash flow towards the next property. If you’re trying to maximize your rate of return and your growth, you’d want to maximize your leverage. While obviously you want to make sure you’re making smart choices and not over extending yourself, paying the mortgages off faster just means eliminating the leverage that you’re benefiting from. If you pay a mortgage off within a year, that’s nearly the same thing as paying cash for it. To my mind, the only time you should pay extra on your mortgages is when you’re shifting focus from growth to cash flow, ie. “retirement”.

    • Mark Ferguson says:

      I agree, I don’t pay them off anymore./

  • “You are also paying down the principle on the loan by an average of $118 each month. That $118 equals another 7% return on your money that you would not have on a cash purchase! ”

    Paying off debt (be it the interest or the principal) is never a “return”.

    • Mark Ferguson says:

      It is a return, but what kind of return it would be could be argued. It is not a cash on cash return, but it could be included in ROI. It is definitely money that is reducing the loan amount that you would not have if you paid cash.

  • What is the time frame you are looking at in paying off all those loans? Or

    • Mark Ferguson says:

      My loans are 30 year amortizations, but they are also ARMs. My strategies keep changing. I was thinking of paying them off as fast as possible, but now I may be selling some houses and buying more or refinancing some.

  • Like most investors that have partial knowledge, you neglect the very important principle of Time-Value of Money. You will not be able to access the principle that is being paid down with your mortgage until you sell or refinance. If you actually analyzed your investment using Internal Rate of Returns (IRR), you likely aren’t doing as well as you think.

    If you pay cash for a property, the full net income of your annual cash flow can be invested elsewhere, capturing additional value versus equity that you cannot immediately access.

    • Mark Ferguson says:

      I agree with that, but if you pay cash for a property you are tying up 80 percent of the value of the investment which cannot be reinvested either. Sure you get all of your income, but what is that $400 to $500 extra a month on a $100,000 deal? It would take over 13 years to get the full $80,000 back that could have been financed and reinvested right away.

  • I see the there is a subtle message here. Buy under valued property, this strategy reduces the risk of not being able to meet your dept repayments eg can sell the property later at a profit.

    I have no doubt the leverage model can work but make no mistake many people have destroyed their lives though speculation funded by debt. i personally know a guy who has been a millionaire made and broke 3 times, he just has the guts to get in there and go for it. The stress on him and his family is enormous, he is also on his third wife and has just been diagnosed with cancer.

    My personal message to all is if you must buy a speculative investment with leverage it is a good idea to have access to the funds to pay out the debt should the need should arise.

    • Mark Ferguson says:

      I do not believe in buying real estate for speculation. I buy for cash flow and hope for it to go up in value.

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