Most real estate investors obtain some sort of financing when purchasing an investment property. Some get a conventional mortgage from a lender, others use asset-based lenders or hard money loans, and it's also not uncommon to borrow against other properties to finance an investment property acquisition.
However, there's also a fair amount of cash buying in the investment property world. More investors choose to pay cash for their properties than do buyers of primary residences.
While there are certainly some benefits to owning an investment property mortgage-free, there are also some drawbacks to this approach. With that in mind, here's a rundown of some of the things you should consider before choosing to pay cash for your next investment property.
Reasons to pay cash
There are obviously some perks to paying cash for an investment property. Just to name a few:
- Cash offers tend to carry more weight with sellers than offers with financing contingencies. Not only does a cash offer show that the funding will be available, but cash buyers can typically close faster as well.
- By paying cash for an investment property, you are more protected against things like vacancies and market downturns. After all, without a mortgage, your ongoing out-of-pocket expenses will be much lower than they otherwise would be.
- The mortgage process can be stressful and complex. Last time I obtained a mortgage on an investment property, I had a total of more than 100 back-and-forth emails and phone calls with my lender, and we barely got final approval by the contract date. Paying cash makes for a much smoother closing process.
More risk = more return
Generally speaking, when you take on more risk with an investment, your long-term return potential will be higher -- all other factors being equal. And leverage (borrowed money) is certainly a form of added risk. After all, if your property sits vacant, you're still responsible for making mortgage payments, which can drain your reserves fast.
However, if you want to earn the best possible returns on an investment property, financing is typically the way to go.
We'll look at a hypothetical investment property in both scenarios -- paying cash and obtaining a mortgage. Let's say that the property you're buying is a $200,000 duplex that generates $2,000 in monthly rent. The property taxes cost $4,000 per year, and insurance is another $1,200. You also pay 10% of the rent ($200 per month) to a property manager who handles the day-to-day operations. Finally, we'll assume that you set aside another 10% of the rent to cover unexpected maintenance costs and any vacancies.
Let's also say that you plan to hold the property for 10 years and that its fair market value increases by 2% per year. After 10 years, this gives you a property value of about $243,800.
Example of investment return when paying cash
First, we'll see what kind of return you'd earn if you paid $200,000 cash for the property. On a cash flow basis, here's how much you'd bring in:
|Property Taxes ($4,000/yr)||$333|
|Net Profit||$1,184 monthly ($14,208 annually)|
Your net rental profit of $14,208 per year represents a 7.1% return on your invested capital on an ongoing basis. In addition, if you sold the property at fair market value after 10 years, you'd have a $43,800 profit. This is a 22% return on your investment, or about 2.0% on an annualized basis.
Combining your rental income with your property value appreciation gives an annualized total return of 9.1%.
Example of using a mortgage
Now let's look at the same property, but with one big difference. We'll say that you put 25% down ($50,000) and finance the rest with a 30-year fixed-rate mortgage at a 5% APR. This would give you a monthly mortgage payment of $805. Your monthly cash flow would now be:
|Property Taxes ($4,000/yr)||$333|
|Net Profit||$379 ($4,548 per year)|
So, while your cash flow would only be $4,584 per year, this represents a 9.1% return on your initial $50,000 out-of-pocket investment.
Plus, after 10 years, your mortgage would be paid down to a principal balance of about $121,700. So, your initial $50,000 investment would get you a $93,800 payday when you sell, a return of about 88%, or about 6.5% annualized. Combined with the property's cash flow, this adds up to a 15.6% total return, which is much higher than the cash-funded example.
To be sure, this is a simplified example. It ignores things like closing costs, loan origination fees, and selling commissions. However, the basic idea is certainly valid -- properties bought with leverage generally have superior return potential. And in all likelihood, your actual returns would be slightly higher, since rent tends to increase over time.
The Millionacres bottom line
The bottom line is that, assuming you can afford it, the decision to buy an investment property with cash or to obtain financing comes down to a question of risk versus reward. If you'd rather take a more conservative approach, there's nothing wrong with paying cash and getting a nice return from your real estate investments. On the other hand, if you have a bit more risk tolerance, you can potentially supercharge your investment property returns by using leverage to your advantage.
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