How Should You Buy Your Next Investment Property?

Investing in real estate -- especially rental properties -- can be an excellent way to build wealth and create a nice stream of passive income. Before you get started, there are a bunch of important decisions to make -- most importantly, how to pay for the properties. Broadly speaking, your two choices are to pay for your rental properties in full or to finance the purchase. Both have their benefits and drawbacks, so let's see if one might be better for your situation than the other.

Cash: safe and easy
It seems like a pretty obvious fact that buying a property in cash is the easiest way to do it. You can generally get the best deal by paying in full, as cash buyers are looked upon very favorably by sellers.  Paying cash also greatly reduces your risk should the housing market go sour, but I'll get into that more when discussing financing. 

So, what type of returns can be had when buying a property in cash? There is no exact formula, but depending on your market, expect to collect 0.8% to 1.1% of a home's value in monthly rent, which we can simplify to 1% for calculation purposes. So, a $100,000 investment property can be reasonable expected to produce $1,000 in rent, or $12,000 per year.

Since the property is paid for in cash, the only real expenses are taxes and insurance, which are usually not more than 2% of the home's value per year, but can be a lot more depending on what area of the country the property is in. So, for our $100,000 example, our total proceeds should be $12,000 in rent minus $2,000 in taxes and insurance, for a $10,000 annual profit, or a 10% return on the $100,000 investment. 

Bear in mind that this doesn't assume that the actual value of the property will appreciate over time. If the home appreciates at historical average rates, your total return could be around 14-15% annually. Not a bad investment, right?

Financing: supercharge your returns, but at what cost?
In any type of investing, higher leverage means more risk but more potential reward. The same is true in real estate. Let's say that instead of buying a $100,000 property in cash, we use that money to buy a $500,000 property with 20% down. 

Using the figures above, we can expect to collect rent of around $5,000 per month ($60,000 per year), while paying about $10,000 in insurance and taxes. However, we now have a monthly mortgage payment of $2026, assuming a rate of 4.5%, which adds more than $24,000 to our annual costs.

So, our total income would come to just under $26,000 per year, or an outstanding 26% return on our $100,000 investment, not including the potential appreciation of the property itself. However, returns like these don't come easy, or without risks.

Source: Flickr / Floyd B. Bariscale.

A word about risk...
If we finance a $500,000 investment property with 20% down, it would leave us with a $400,000 mortgage. Let's say that the real estate market takes another downturn for whatever reason, and our property is now worth $450,000. Our equity in the property is now just $50,000, meaning that half of the original $100,000 investment is now gone! 

The cash buyer, on the other hand, would have only lost 10% of their investment in a similar downturn. While I think a downturn like this is unlikely, and these losses would just be "on paper" unless the property is sold, it is definitely a real risk that all investors who consider financing should be aware of.

How much do you want to work?
It is also worth noting that both calculations above assume that you maintain and find tenants on your own, as opposed to hiring a property manager (which costs around 10% of the rent collected). This is fine, and completely feasible for someone with the time on their hands to manage their own properties, but consider how much more work we're talking about on a $500,000 multi-family property than a $100,000 single-family home.

Which is best for you?
While returns of 26% (or more) sound very enticing, make sure you know exactly what you are getting into before you decide to finance your next rental property. Factors to consider include, but are not limited to, the stability of your local housing market, average rents in your area, current mortgage rates, insurance costs, and how much income you expect to make.

There is no one-size-fits-all answer to this, but the best way to protect yourself in any investment is to hope for the best and plan for the worst. If you feel like you could survive the worst-case scenario, financing may indeed be the best way to go for you, but there is nothing wrong with playing it safe. After all, a double-digit return is still pretty impressive, and can really help create wealth over the long run.

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Matthew Frankel

Matt brought his love of teaching and investing to the Fool in order to help people invest better, after several years as a math teacher. Matt specializes in writing about the best opportunities in bank stocks, real estate, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!

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