I have an infatuation with real estate. I love researching and working on houses. As part of this interest, rental real estate is something I want to incorporate into our investment strategy. We currently have one rental property, which is the first home I bought and just never sold. But I want more. The “relatively passive” income from real estate is very appealing. The sooner we can get the rental snowball rolling the better the benefits will be.
I’ve been debating whether we should purchase the next one with all cash or by financing. I figured I might as well put my thought process out on the blog for transparency.
Building a Model
When I am weighing financial decisions the engineer in me screams out for a numerical model to simulate how each method would work out. I’ve built a model based on a “typical” property in my region (the St. Louis area) and our existing rental property. Here are the assumptions for this “typical property”
- Purchase Price = $70,000.00
- Rehab Required = $5,000.00
- Monthly Rent = $1,000.00 (rent will increase, but so will costs so I am keeping this static)
- Vacancy = 10% ($100.00)
- Monthly Average Maintenance (service calls, minor repairs) = $50.00
- Monthly Capital Expense Savings (i.e. savings up for a Roof, HVAC, etc.) =$150.00
- Property Management = 10% ($100.00)
- Monthly Insurance $75.00
- Monthly Property Taxes (2% of appraised value/purchase price) = $95.00
- Monthly Sewer Bill (based on current rental) = $75.00
- All other utilities are under the tenant
The Financing Assumptions are as follows:
- 25% Down Payment
- 3.5% Mortgage Interest
- 15-year loan term
This property has just about zero monthly cash flow (-$20 actually). Rather, cash flow is essentially deferred until the mortgage is paid off. In comparison, an all cash property has a positive monthly cash flow of $356.
These numbers are not great, but it’s what I see out there right now. Further, actual month to month cash flow will typically be much higher as long as it is rented. But those vacancy and capital expenses should reasonably be included in the forecast as they will almost certainly be incurred at some point over a long buy and hold timeline.
Lastly, as part of the model there will be $2,000 in monthly contributions to save up for purchasing rental property.
For full disclosure, there are a several ways to buy properties (hard money loans, wholesaling, etc.). For the sake of an apples to apples comparison, I am assuming I can repeatedly purchase the same deal with either all cash or financing. That’s a big if.
In this model a new “typical” property is purchased as soon as the sum of cash flow and monthly savings is enough to do so. For the financing option, this would occur once $27,576 is saved up while the all cash approach requires $79,000. This purchasing plan stops after 20 years on the basis that the goal is to more or less be retired at that point. Also, properties are not sold off in this scenario, nor are they appreciating in value.
Let’s take a look at where each strategy would stand at 5, 10, 15 and 20 years.
I should note that the cash flow in the Finance Option will start to dramatically increase as the 15-year mortgages are paid off.
The Case For Financing
Faster Growth
Financing allows us to acquire a property for approximately 25% of the purchase price. From the model above, we are able to acquire 15 properties essentially for the price of 9 with the all cash option over 20 years. At the end of the time period the value of the properties under control is roughly $400,000 more than the all cash portfolio. In reality, the difference would be higher when you factor in price appreciation.
However, at a certain point, it will be difficult to continue obtaining standard financing. Many lenders will cut you off once you have 6 mortgages. When this occurs you would need to look at other options like hard money lending or similar.
Empire Building
If you play the game long enough all those mortgages will start to pay off. Many real estate investors start to add the positive cash flow to the remaining mortgage balances to “snowball” the pay them off quicker than the loan terms. Once they are all paid off the cash flow would be immense. 15 paid off properties would cash flow approximately $64,000 a year! This approach would also allow you to leave a large portfolio to your estate if you chose to do so.
More Diversification
Since financing allow us to purchase more properties and faster, we can diversify our risk. If I own 15 properties and 1 has a prolonged vacancy or major repairs, it doesn’t matter as much as if it was 1 of 9 properties.
The Case for Cash
Less Risk
Owning the houses reduces the monthly stress of hoping the net rent will cover the mortgage costs. In the event there is a sudden loss of income it would be much easier to keep things moving compared with the plan to finance.
Also, if things go south you can quickly sell it without necessarily involving a lender, or in a worst case scenario, refinance the property to pull your equity out.
Cash Discount
If you can make all cash offers, then you can close faster with much fewer contingencies. This can make your offer more valuable to a seller. Also, many wholesalers require buyers to be all cash. I will note that there are workarounds, such as hard money loans, that allow you to make a cash offer, but these require added complexity and higher lending costs.
Front Loaded Cash Flow
As can be seen from the model, positive cash flow is achieved immediately. This is very attractive as the sooner cash flow can cover expenditures, then the sooner you can move on from your 9 to 5.
Simplicity
It’s easier to manager less properties than more properties. With 15 properties you have 15 roofs and 15 water heaters, etc. That’s a lot more than 9 in the all cash option. Further, it can be challenging to keep track of making payments to multiple lenders.
Also, any interruption in rent payment could lead to a chain reaction. If you are over-leveraged and barely making the monthly payments, this disruption could bring down your empire like a house of cards. With hard money lenders, you could quickly face foreclosure, or maybe even lose a kneecap if they run in rougher circles. Ha!
What Are My Goals?
Clearly, there are benefits associated with either route. But getting back to the root of the issue, I am looking for passive income to cover our living expenses. Specifically, we would like to leave our current 9 to 5 jobs (more like 7 to 5!) by the time we are 50, 15 years from now. However, managing a real estate empire doesn’t hold much appeal. At the end of the day, time is what I am trying to acquire, not another job.
With two kids to look after, the volatility associated with being leveraged into multiple mortgages is tough to accept.
Real Estate is just one piece of our retirement puzzle. We are maxing out our 401ks and HSAs, and contributing to a taxable brokerage account, so we will have the ability to draw on these accounts during traditional retirement. As a result, we won’t have to rely on the real estate portfolio to fully support us.
In summary, the all cash option is the one that appeals most to me. I believe it would get us where we would need to go with the least risk and hassle. However, if we were thinking of getting started in our early twenties, then I would more seriously consider the finance approach as the mortgage snowball would be rolling fast by the time we approached retirement.
Next time we will look at whether it’s best to just invest in the stock market and avoid real estate altogether.
This was the strategy I employed and I retired recently at 46. The only thing I would say is that I seriously underestimated maintenance costs. In part this was because 2 of my properties were old heritage houses and one was an aging block of units, but if I had my time again I would have paid more attention to this issue. Good luck!
We have a large part of our investment portfolio in real estate, and we have a mix of financed and paid off. We used a self-directed retirement account to buy some of our real estate, so these are all cash — you can get loans but we didn’t want to bother with the requirements. On the other hand, we financed our other properties and even cash-out refinanced where we could b/c we already have so much tied up into real estate in terms of down payment equity, we wanted the rest to be more liquid. As long as your rentals still cash flow with the mortgage — and yes, you need to budget for maintenance which is always higher than you expect! — we’re definitely team mortgage for the reason that once you pay the bank back its money, you can’t get it out without another loan, selling outright, or some other hassle.