When investing in real estate, your choice of financing, or lack thereof, is one of the biggest factors which determines your return on investment. Real estate is one of the few asset classes where financing is readily available for buyers with good credit, stable employment, and adequate cash reserves. So you should definitely take advantage of it if you qualify, especially with the hysterically cheap rates of today.
In this post, I’ll provide examples of different kinds of rental property financing and hopefully show why you should never pay cash for rental properties, especially when you can get dirt cheap money.
Note: Since this post involves a lot of numbers and calculations, I’ve erred on the side of too much detail instead of too little. I hope you’re able to follow the examples and if you have any feedback to make them more readable, please leave me a comment.
To ensure that the comparison is fair, all of the examples will use the same house with the following characteristics:
100,000 market value
1000 fixed closing costs
=79,000 total cost (price + repairs + fixed costs)
1000/month or 12000/year rent, minus
2200/year property taxes, minus
=9100/year net operating income (NOI)
The NOI doesn’t include maintenance, vacancy, management and utilities.
- Maintenance will hopefully be low for the foreseeable future because we are putting $18,000 in repairs. Additionally, our lease makes the tenant responsible for many small maintenance issues.
- Vacancy is more or less under your control. If you have a good tenant they will notify you within 30 days that they are leaving. If you are a good landlord, you’ll know ahead of time, perhaps a few months. If you’re a really good property manager, you can have another tenant lined up to move in within a week or two of the old one moving out.
- We do our own property management and I recommend you do too. No one cares about your property as much as you do.
- If you were trying to live off of this income then you should absolutely reserve some funds for maintenance and vacancy so that you can have more stable month-to-month income. You wouldn’t want an unexpected repair in your business to mess up your personal budget.
This is a pretty typical deal in my area but if you want to follow along at home, feel free to substitute your own numbers.
Ah… cash. Cold, hard cash can make your offer very attractive to sellers. Your ability to close in a matter of days can mean the difference between an accepted offer and a rejection notice. When paying cash, you can often get a better price because a cash offer is seen as more likely to close than an offer which is contingent on financing.
With a cash purchase, your expenses are going to be low. Finance costs are usually the largest monthly expense so when you pay cash, you get to put that extra money in your pocket. This makes cash attractive to some people who see that $400-500 mortgage payment and cringe get when they have to write that check to a bank.
Let’s do the numbers. Since you’re not using financing, your returns are easy to calculate:
$9,100 income, divided by
=11.5% cash on cash return
$100,000 value, minus
= $21,000 equity capture/unrealized capital gain
I’m using this figure as an illustration and it doesn’t represent the amount of money you would actually put in your pocket when you sell. Your realized capital gain when you sell would be affected by transaction costs and taxes. Transaction costs in real estate are very high and n a perfect world, you would just sell it to your tenant and avoid listing it with a realtor. If you want, you can take an extra $8,000-$10,000 off of the capital gain to reflect these costs.
$21,000 cap gain, divided by
=26.5% return on capital gain
Those numbers are pretty respectable! Some of you might look at that and say, “Well, hell! I’d do one of those deals every day!” But unless you’ve got a huge bankroll, you probably couldn’t do very many of these, and probably not one every day. Most people would have to borrow some of that money to continue building their portfolio.
A loan from a bank will let you borrow most of the purchase price. This can really juice your return as you can get control of a 100k asset by paying for a fraction of it and using “other people’s money” (OPM) for the rest of it.
One major downside: banks move really slow! A bank loan will take at least 30 days to close and that makes your offer less attractive to sellers.
Additionally, banks will only lend against properties which are habitable. So if there’s no flooring or a leak in the roof, there’s no way to get a bank loan and you’ll have to buy it and fix it with cash or some other form of financing from the list below.
Finally, with a bank loan, you are left paying for all of the repairs out of pocket. If you’re using a bank loan, the property is probably in good condition but there is almost always a little something you will need to do to get it into rentable condition.
For the purposes of this discussion, we’re going to assume that the bank will finance the example property, even with the amount of repairs required. This example would be pretty boring if I just said “The bank won’t lend on this one so let’s move on”
Let’s run the numbers on this one. We’re going to use a 20% down payment which means we’ll use an 80% loan. We’ll use 5% interest rate on a 30-year fixed loan for the examples going forward.
=$48,000 loan and a $12,000 down payment
This will add probably $2,000 in closing costs between the appraisal and other lender fees:
$79,000 cost, plus
$2,000 in additional fees is
=$81,000 financed total cost
$81,000 financed cost, minus
= $33,000 out of pocket
This includes: $12k down payment, $18k in repairs, $3k in closing costs.
5% interest on a $48,000 loan gives us
= $257.67/mo or $3092/year in debt service
$9,100/year Net Operating Income, minus
$3,092/ year debt service
= 6008/year in Cashflow
Finally, we can calculate the returns:
6008/year in cashflow, divided by
33,000 out of pocket
= 18% cash on cash return
100,000 value, minus
81,000 financed cost
= 19,000 equity/unrealized capital gain
19,000 cap gain, divided by
33,000 out of pocket
= 57.5% return on capital gain
Wow! So just financing 80% of the purchase price can really juice your return: an extra 6.5% cash on cash-on-cash and more than double the return on capital gain.
The downside is that your actually cashflow amount went down by $3k a year and your holding costs went up in case of vacancy. Personally, this is a small price to pay for the added return.
Plus, since your total out of pocket was less than half of the cash scenario, you could actually afford to buy two of these bringing your total cashflow to $12,016/year and your total unrealized capital gain to $38,000! This is really key to building wealth with real estate: using your limited funds to buy as much property as safely possible. Too much leverage is a bad thing – we want to use just the right amount.
This brings me to my favorite method of financing: hard money. Hard money, sometimes called a bridge loan or construction loan, is a short term, high interest, interest-only loan made by an individual or a private company. These loans are usually targeted at real estate investors because it allows you purchase distressed property with a short closing period.
One of the biggest advantages of hard money is that the loan can be used for repairs. The loan amount is usually a percentage of the “after repair value” (ARV) of the property. Around here, it’s easy to find 70% ARV loan for rentals and a 65% ARV loan for flip properties. If you can buy a property for less than 70% of the ARV, then you can use the rest of the funds for repairs and sometimes closing costs.
Another advantage of hard money is the quick closing. Typically, hard money can close in about a week, putting it on par with a cash offer.
The biggest downside to hard money is the cost. The hard money companies in my area charge 14% interest-only and 3 points to fund the loan. I’ll say that again: 14% interest-only and 3 points.
People look at those numbers and think that someone would have to be crazy to pay that much! I want to point out two things before we do the numbers:
- this is short-term financing so after you get it fixed up and rented you can start the refinance into a bank loan. Your goal should be to get out of hard money within 3 months of purchase.
- You’re paying for the speed at which you can get this money. A quicker closing means you get more accepted offers.
With that said, lets dig into the numbers:
The hard money loan amount is 70% of,
$100,000 market value
=$70,000 loan amount
Hard money will add 3 points to the closing cost plus a few other costs from the lender: document prep, credit check, processing fees, appraisal, etc. We’ll call that $1,000.
3% of $70,000 = $2,100 in points
$2,100 in points, plus
$1,000 in other finance costs
=$3,100 in closing costs
Since the loan amount is higher than the purchase price, the extra funds can be used for the repairs. Typically the repair funds are held in escrow by the lender and released as the work is completed. This means that you have to pay for the repairs out of pocket first before being reimbursed by your lender.
But wait! Remember that hard money is a two-step process: purchase with hard money, refi with a bank loan. That means we’re going to have two sets of closing costs:
$79,000 cost, plus
$3,100 in hard money closing costs, plus
$2,000 in bank loan closing costs
= $84,100 total property cost
Our final loan is going to be 75% loan to value, at 5% interest
$100,000 market value
=$75,000 final loan amount
$84,100 final cost, mins
$75,000 final loan amount
= $9100 total out of pocket
Basically that’s all costs minus all the money provided (from the biggest of the two loans, the second one).
5% interest on
= $402.62/month or $4831/year in debt service
$9,100/year Net Operating Income, minus
$4831/ year debt service
= $4269/year in cashflow
Don’t get depressed yet! That number is a lot lower than the cash example – It’s less than half! But look at your returns:
$4,269/year cashflow, divided by
$9,100 out of pocket
= 46.9% cash-on-cash return
$100,000 market value, minus
$84,100 final cost
= $15,900 unrealized capital gain
$15,900 capital gain, divided by
$9,100 out of pocket
= 174% return on capital gain
No joking – that’s some serious return. You basically doubled your money the day you bought the property. In just a hair over 2 years, you will have all of your initial investment back but the property will continue to cashflow at $355/mo.
With an out of pocket of $9,100 you could buy eight properties with the same $79,000 you used to pay cash for one. Eight properties would give you a total cashflow of $34,152 and a total unrealized capital gain of $127,200.
So in the end, the financing which looks to be most expensive on paper actually ends up giving us the highest return. The trick is that hard money is just the right amount of leverage: 70% ARV on the purchase and 75% loan to value on the refinance. With 25% equity, you can still cashflow handsomely and the amount of leverage lets you use a good amount of other people’s money.
There are a ton more financing options: construction bank loans, private money, lines of credit, seller financing… the sky is the limit. The ones I highlighted are probably the most common ones.
Some people are so debt-averse that they are literally leaving thousands of dollars on the table just to avoid taking on any more debt. I want to emphasize that this debt is for your business and it’s making you money. In some cases, a lot of money.
If you are worried about making the mortgage then consider this. Which is safer: having 1 tenant or having 8 tenants? With only 3 properties, the cashflow from 2 of them would be enough to cover the payment on 1 if it goes vacant. With 8 properties, 2 of them could go vacant and you could still pay the bills and put some money in your pocket.
If you were a hardcore cash buyer before, I hope you will at least consider using some financing on future projects. It could mean the difference between a 10% and a 50% return!
Photos by 401k
Update: A forum moderator by the name of arebelspy over at the Mr. Money Mustache forum wrote some great criticism about this post. I’ve since updated the post to reflect some of his points but I hope you’ve gotten the message here: that leverage is a powerful tool for building wealth, if used properly.