Paying cash for rental properties may seem like the safe bet, but it may actually be costing you a lot of money. I am trying to buy as many rental properties as I can because of low-interest rates, and the incredible returns I am seeing on my current rentals. Many people feel paying cash is the best option when investing, but when you get a loan, you increase your returns substantially. You cannot get the incredible returns I get or buy nearly as many properties if you pay cash. I am making over 15 percent cash on cash return on all 16 of my properties. I explain how I do this in my complete guide to purchasing long-term rental properties.
The key to my strategy and obtaining great returns is being able to leverage my money. Leveraging is using other people’s money for investments so you use less of your own money. By using other people’s money, you can buy more properties and increase your returns on the total cash invested. If you pay cash versus getting a loan, your returns decrease dramatically, and all the benefits of owning rental properties decrease as well.
Why do you get a higher return on your money when you get a loan instead of paying cash for a rental?
I am going to use some basic figures to outline the benefits of leveraging your money. If you buy a $100,000 house with cash and make $500 a month in cash flow, you are making about 6 percent cash on cash returns. Cash on cash return is the return you are seeing on the cash you have invested into the property. If you buy a $100,000 house and put 20 percent down, you will have a mortgage payment, but the returns on your cash invested increase because you are using much less cash. If you are paying a 4 percent interest rate, your principal and interest payment will be about $382 (check out the bank rate mortgage calculator for calculating mortgage payments). You are only making $118 a month cash flow after subtracting the mortgage payment, but you are making 7 percent cash on cash return due to the lower initial investment.
Additional benefits of getting a loan on a rental property
Even though the cash on cash return is 7 percent, you are actually making much more than a 7 percent total return in the above scenario. You are also paying down the principle on the loan by an average of $118 each month. That $118 equals another 7 percent return on your money that you would not have on a cash purchase! You have more than doubled your return by getting a mortgage instead of paying cash. The exciting part about using leverage is when you get a higher cash flow, the returns increase even more. If you can make $800 a month cash flow without a mortgage, you will be making 9.6 percent cash on cash return. With 20 percent down on the same property, you would cash flow $418 a month after the mortgage payments and make over 25 percent cash on cash return just from cash flow! The way to make big money in rental properties is finding properties that will give you big cash flows and buying as many as possible, while leveraging your money. I make over $500 a month cash flow on each of my properties because I leverage my money.
You can buy more houses when you leverage rental property
The best part about leveraging your money is it allows you to buy more properties. You can buy three or four homes with $100,000 instead of just one home paid for with all cash. Using the cash flow figures from above and buying three properties instead of one, you are now making $1,254 a month cash flow instead of $800 a month. Not only does your cash flow increase by purchasing more properties, but the equity pay down increases, the tax benefits increase and the appreciation increases. If you can purchase homes below market, then every time you buy a home, your net worth increases as well!
The advantages of rental properties are multiplied when you buy more houses
Rental properties have many tax benefits including depreciation. The IRS allows you to depreciate a percentage of your rental properties every year and write that off as an expense. If you have three houses instead of just one, you can get triple the tax deductions.
If you have three properties instead of one and the market appreciates, then you also have the benefit of triple the appreciation. It is the same situation if rents go up, the more properties you have, the more money you will make. I never count on rents to go up or appreciation, but it is a nice bonus.
With multiple rental properties, you are also paying down the loans on three properties, which increase your returns as well. When you think of the tax savings, possible appreciation and equity pay down the returns shoot through roof.
What are the downsides to buying more rental properties with loans?
There is a downside to more properties. You will have to pay more for repairs and improvements since each property will need repairs, not just one. You will also have three rental properties to manage instead of one. However, if you are able to cash flow $400 or more with a mortgage, you will still be way ahead of the game by leveraging your money. You will also have more total cash flow coming in, which can pay for a property manager. We accounted for the repairs and maintenance when we figured the cash flow, so it won’t be an added expense with more properties, but it will be more work if you manage the properties yourself.
Some people think it is less risky to buy with cash than with a loan, but I would also disagree. Here are some reasons why cash may be more risky than getting a loan.
- When you buy with cash you have less properties. The fewer properties you have, the less sources of income you will have coming in, and the more a loss of an income will hurt. If you have 1 property paid for with cash, it really hurts when it goes vacant. That is your only source of income from rentals. But if you have three rentals that have loans on them, one may go vacant, but you have two more that are bringing in money.
- When you have multiple rentals, you also have more diversification. If you happen to have one rental, you are more susceptible to neighborhood changes, storm damage etc. With multiple rentals you have less of a chance of all your properties being damaged or hurt by other factors.
- You actually lose less money when prices go down with multiples properties. I know that may not make sense at first, but consider this. If you buy three houses below market value for $100,000 (they are worth $125,000 when you bought them) and the market goes down 20 percent. Your houses would be worth $100,000 so you are not losing any money if the market goes down and you bought below market value. If you bought one house with cash below market value you would be in the same boat. If you are able to get even better deals and bought the houses for $90,000 that were worth $125,000 then you would actually still be in good shape if the market goes down 20 percent. You would have three houses worth $100,000 that you bought for $90,000. You would have $30,000 in equity from buying below market value. If you only bought one house for $90,000 with cash and the market went down 20 percent, you would only have $10,000 in equity from buying below market value. This number can be manipulated to show how cash or a loan is better depending on how much the prices decrease, how much of a discount you bought the houses for in addition to other factors. But this shows that cash is not always going to be the safest bet.
If you are wondering if it is smart to pay cash for a rental, consider the returns you may be giving up. In my opinion, it is better to use other people’s money and increase your returns versus paying cash. Some people are very averse to any risk and do not want any debt at all. If the idea of debt makes you sick to your stomach, maybe paying cash versus getting a loan is the best route for you. I will continue to get as many loans as I can and to buy as many rental properties as I can because of the incredible benefits rental properties offer.