Rental Property Financing, or Please Don’t Pay Cash

Hopefully you used someone else's money

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.

Assumptions

To ensure that the comparison is fair, all of the examples will use the same house with the following characteristics:

100,000 market value
60,000 price
18,000 repairs
1000 fixed closing costs
=79,000 total cost (price + repairs + fixed costs)

1000/month or 12000/year rent, minus
2200/year property taxes, minus
700/year insurance
=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. :)

No Financing

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
$79,000 cost
=11.5% cash on cash return

$100,000 value, minus
$79,000 cost
= $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
$79,000 cost
=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.

Bank Loan

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.

80% of
$60,000 price
=$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
$48,000 loan,
= $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.

Hard Money

The ones I usually get have dollar signs on them

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:

  1. 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.
  2. 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

75% of
$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
$75,000
= $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.

Conclusion

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.

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32 Comments

  1. Nick
    Posted February 22, 2012 at 10:33 am | Permalink

    Nice post, DD. I used OPM last year to buy a nicely cash-flowing property with 25% down. I’ve recently learned about homepath loans, which only require 10% down with no PMI. Now if I can just find a good deal on one of those I’ll be all over it. That kind of financing will let me do two deals for the price of one :)

    • Dollar D
      Posted February 22, 2012 at 10:37 am | Permalink

      That’s great! Congrats on your purchase.
      Correct me if I am wrong but homepath is only for owner occupant, right? I didn’t think you could use it as an investor.

      • photohunts
        Posted February 22, 2012 at 10:55 am | Permalink

        Homepath works for investors. 10% down for investors, some lenders require 15%. The lack of PMI is offset by the higher interest rates over a conventional loan. On paper, I would argue they are the best deal for traditional financing options. They can only be used for properties listed on the homepath website.

        • Dollar D
          Posted February 22, 2012 at 11:05 am | Permalink

          Interesting. I’ll have to look more into this. Thanks for the info!

  2. photohunts
    Posted February 22, 2012 at 10:51 am | Permalink

    Great examples on these three financing options. I’m not sure about your area, but the HML in mine, at least the good ones, require that you have substantial cash reserves to cover the interest payments and holding costs for the entire term of the HML. Also, it didn’t look like you accounted for the hard money interest payments for the months you are doing repairs and trying to refinance.

    Also keep in mind that although you may have enough cash to keep acquiring properties, you are limited to the number of loans you can get from a certain lender class. Traditional banks like to see income from two years worth of tax returns before they will adjust your debt to income ratio. Depending on your lender, there may also be a limit to the total number of mortgages you can have.

    • Dollar D
      Posted February 22, 2012 at 11:02 am | Permalink

      You’re right, you definitely need some cash reserves with hard money, both for the interest payments and for the repairs before being reimbursed. You’re also right that I didn’t factor in the holding costs. I probably should have but I was already throwing out a ton of numbers so I thought I might keep it as simple as possible.

      Typically you will make 3 months of hard money payments before the refinance and of those 3 payments, you will ideally have a renter for 2 of them. After you refinance, your next payment will typically be a month later so you have a month without any payments. So, two payments minus two months of rent is probably $200-$300 plus one full payment on your own of around $800. So you can approximate holding costs to be around ~$1,000. This is under ideal circumstances of course.

      You are typically limited to 10 bank loans before FannieMae says you can’t have any more. After that, you have to turn to alternative financing: commercial and private lending. Personally, I think that’s a good problem to have: it means you’ve got a lot of properties! We’ll cross that bridge when we get to it. Hopefully soon :)

      • photohunts
        Posted February 22, 2012 at 11:26 am | Permalink

        That would definitely be a good problem to have. For private lender/investor leads, I think you already have a good marketing tool with this blog.

        • Dollar D
          Posted February 22, 2012 at 11:33 am | Permalink

          You’re probably right about the blog! I haven’t really told anyone about it but if I were courting a potential investor, i’d probably point them to the case study or FI Update.

      • Jonathan
        Posted February 22, 2012 at 12:16 pm | Permalink

        Yeah the 10-property limit concerns me – not sure what we’ll do when we get there. Options would include: 1) saving up all cash flow from the first 10 to buy an 11th with cash (super slow option); 2) selling one property (which has hopefully appreciated) and use proceeds to pay down a second loan, eliminating 2 mortgages (probably wouldn’t work, as if property values have gone up significantly our investment strategy would no longer work for new investments); 3) Paying off the smallest or cheapest mortgage with cash (similar to 1); 4) finding a new financing strategy.

        • Dollar D
          Posted February 22, 2012 at 12:24 pm | Permalink

          One option that some people pursue is using commercial financing. You take a few properties, say 3 or 4, and move them into an LLC and get a commercial loan to pay off the personal loans. The downside is that the commercial financing is more expensive but the option is there.

          As a second option, you could take on partners. You bring the skill, time, and some of the funds. The partner brings the most of the funds and their credit. The property remains in both of your names but the mortgage is only in the partner’s name, thereby freeing up your credit. We’ve got a deal like this in the works with one of my wife’s friends. I met a guy the other day who has 13 properties, some of them were purchased with partners using this method.

          For us, when we hit that limit we’ll probably start selling off the ones we’ve held the longest and start rolling those funds into an apartment complex deal. Or maybe we will have found a good source of private money by then.

          • Jonathan
            Posted February 22, 2012 at 1:08 pm | Permalink

            I like both of those ideas. I forgot, we are exploring partnerships as well (not very actively yet). And definitely getting a commercial loan would be a viable option (or, alternatively, getting a line of credit and using it to pay off mortgages…though this is clearly a riskier option).

  3. Posted February 22, 2012 at 2:08 pm | Permalink

    the more I read your blog, DD, the more impressed I am. This is one of your best. Clear, concise and interesting.

    I’ll be linking to it in one of my own coming up shortly:

    Rent v. Owning Your Home, opportunity cost and running some numbers

    thanks!
    jlcollinsnh recently posted..The Casanova Kid, a Shit Knife, a Good Book, Having No Regrets, Dark Matter and a bit of MagicMy Profile

    • Dollar D
      Posted February 22, 2012 at 3:01 pm | Permalink

      Thanks, JC! I was worried that I was running on too long. I’m really glad you liked the post. Can’t wait to read yours!

      • Posted February 22, 2012 at 3:35 pm | Permalink

        it’s coming. I have it in the hands of a trusted advisor checking my numbers.

        forgot to ask about your post…..

        …..this is such a buyer’s market I was a bit surprised at your comments on cash and hard money being attractive to sellers. As a seller any potential buyer that can fog a mirror looks good to me. :)
        jlcollinsnh recently posted..The Casanova Kid, a Shit Knife, a Good Book, Having No Regrets, Dark Matter and a bit of MagicMy Profile

        • Dollar D
          Posted February 22, 2012 at 3:39 pm | Permalink

          That might work if you are trying to sell your own house and not getting any takers. But an appropriately priced foreclosure in this market will be sold within 10 days. Competition among investors for these properties is fierce so you need to make your offer very attractive.

          • Posted February 24, 2012 at 2:23 am | Permalink

            that makes sense, but seems counter to the glut I read about.

            where are you located DD?
            jlcollinsnh recently posted..Rent v. Owning Your Home, opportunity cost and running some numbersMy Profile

          • Dollar D
            Posted February 24, 2012 at 10:04 am | Permalink

            A few miles north of Dallas. Texas has been put on a pedestal during the housing bust as a place for people to put their money. I think that’s driven the competition up in recent years.

  4. so
    Posted February 22, 2012 at 2:14 pm | Permalink

    Have you ever had a seller carry back the note? Most sellers here have absolutely zero interest…

    • Dollar D
      Posted February 22, 2012 at 2:59 pm | Permalink

      All of our purchases have been bank-owned property so seller carry back is not available in that case. I haven’t tried it personally but my guess would be that only the most desperate, and savvy, sellers would even consider it. Most sellers probably just want nothing more to do with the house and they probably need the money out of it now.

  5. AEBinNC
    Posted February 23, 2012 at 11:58 am | Permalink

    I was speaking with a loan broker about a year and a half ago and she advised me that it was almost impossible to get a loan with only 10% down. She advised I would need around 20% down to qualify for a loan and it would be better to have 25% down to get the lower interest rate.

    After hearing that I reviewed my finances. My wife and I had been keeping mostly seperate finances and I took over her portion of things. She had a car loan that was at 8% so I had that paid off first.

    Now I have about 15k saved and add 2k to it each month. Once I hit 30k I’ll get serious about buying a rental. Thanks for the finance overview. Matches up pretty well with the various books I’ve been going through.

    • Dollar D
      Posted February 23, 2012 at 12:39 pm | Permalink

      Yeah, for rental properties you can’t get away with less than 20% down these days. At least if you go to a bank. There’s other methods like VA-vendee or homepath, as another commentor mentioned. But these are only available for certain properties.

      If you are interested in buying and fixed foreclosures, you should seriously consider hard money. Qualifying for a refinance is a lot easier than qualifying for a purchase and if you do it right, you only have that expensive loan for a few months.

  6. Posted February 23, 2012 at 6:51 pm | Permalink

    I’m definitely in the finance camp especially at this interest rate. In 10 years, you can be sure inflation will be much higher than now and the rent will go up.
    I’ll look at the numbers in more detail tonight. Good post.
    retirebyforty recently posted..Save Money With CraigslistMy Profile

    • Dollar D
      Posted February 29, 2012 at 1:29 pm | Permalink

      *Especially* in this low interest rate environment, it would just be silly to pay cash. I’d borrow a ton of money, as much as they would lend me, at 5% over 30 years. It’s easy to make more than 5% in real estate.

  7. Posted February 24, 2012 at 10:21 am | Permalink

    I always prefer financing, ESPECIALLY at these rates. I’m refinancing the primary right now at 2.625% for 5 years, and I just can’t believe it!

    It’s simple accounting, and what you believe being liquid and having optionality means to you.

    Excellent analysis.
    Financial Samurai recently posted..Should A Credit Check Be Allowed Or Required By An Employer?My Profile

    • Dollar D
      Posted February 29, 2012 at 1:30 pm | Permalink

      That’s an incredible rate! I don’t know if we will see these kinds of rates again for a long time.

  8. Dave
    Posted March 27, 2012 at 8:22 am | Permalink

    I am VA Vendee financing approved. I am not a veteran. The terms of this Va Vendee allow non-veterans a chance to buy as an investment with 5% down. I have found three properties. Each time my realtor moves forward, he comes back and says that even though the property was listed as Va Vendee approved, it is not. I’ve heard of bank titleing issues and on the latest one, he came back and said after checking, even though it said Va Vendee in thelisting notes , that I (the buyer) did bot qualify to use the Va Vendee financing I had secured. What the heck is going on here. Extremely frustrated..

    • Dollar D
      Posted March 27, 2012 at 10:13 am | Permalink

      It sounds like these listing agents are jerking you around…

      In my area, they list potential short sales at rock bottom prices. But when you contact them, you find out that the bank hasn’t approved that price and that it was all a ploy to get more offers.. Ridiculous!

  9. dave
    Posted April 2, 2012 at 8:03 am | Permalink

    It’s looking more and more like what you say. I have now just “lost” the fifth property. This time I was told from my broker that the notes in the MLS attached to the property specifying the property as VaVendee approved were incorrect. The property notes never should have had the information listing the property as Va Vendee approved.

    I am extremely jaded now. The VaVendee program is appealing because of the low down payment and option to buy if not military affiliated.

    • Dollar D
      Posted April 2, 2012 at 9:14 am | Permalink

      Yeah, that’s really disappointing! I’d be careful with those extremely low out of pocket programs anyway. Without sufficient equity, your cashflow will suffer. Maybe the option is to get a little more cash reserves and use a different tactic? Don’t lose hope!

  10. kam
    Posted April 11, 2012 at 5:24 pm | Permalink

    I had bad credit and last year withdrew from my 401K to buy a foreclosed home ($63K) which I turned into a B&B, then bought the home next store for rental ($25K). How can i minimize paying income taxes on my 401K withdrawals? Thanks.

  11. Posted May 29, 2012 at 12:22 pm | Permalink

    Dollar D- I’m concerned about the current economic state and how it will affect RE financing. Can you offer an insight as to when this will end/if the upcoming presidential election will have an effect on the marketplace?

    • Dollar D
      Posted May 29, 2012 at 4:23 pm | Permalink

      Banks are still lending for well-qualified borrowers: I can personally attest to that. I think that we’ve hit the bottom, in terms of prices, and that it will (hopefully) still be a good time to buy for another year or two. I’d like to scoop up a few more foreclosures before they are all gone.

      Regarding the presidential election, I don’t foresee any real impact here. I also doubt that congress will make any changes to the tax laws surrounding real estate given how many of them own property themselves :)

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