Many investors choose to pay all cash for an investment property. Back in 2012, BiggerPockets and Memphis Invest conducted a nationwide survey of American citizens and discovered a number of interesting facts, including that 24% of U.S. real estate investors were using 100% cash to finance their investments.
To be clear, even when investors use terms like “all cash,” the truth is, no “cash” is actually traded. In most cases, the buyer brings a check (usually certified funds, such as a bank cashier’s check) to the title company, and the title company writes a check to the seller. Other times, the money is sent via a wire transfer from the bank.
This is the easiest form of financing, because there are typically no complications, but for most investors (and probably the vast majority of new investors), all cash is not an option. However, let’s talk about this for a moment longer.
There exists a debate in the investment world about using cash for a property versus getting a loan. In one camp, you have the “no debt” people, who say a person should only invest in rental properties if they can pay all cash for the deal. The “leverage” camp responds with the math that shows that a person using leverage can obtain a much better ROI by using a loan.
The “no debt” camp fires back, “But 100% of foreclosures happen to people with debt.” And the debate rages. Who is right? If you had $100,000, would it be better to buy one house for $100,000 or five houses with a $20,000 down payment on each?
Once again, I don’t believe there is a right answer, but rather a right answer for you. In other words, what works for me might not work for you. Your decision to use debt will depend heavily on your personal finances, your goals, your age, and other key factors.
Using all cash is safer in some regards, of course. If you owned a piece of property worth $100,000 without a mortgage, you could easily sell the property if you needed to. If the property was tough to rent out, you could afford making the tax and insurance payment to keep the property floating until a renter began to pay. For simplicity, let’s say that the house rented for $1,200 per month, taxes and insurance were $200 per month, and all other expenses, over time, averaged $400 per month (repairs, vacancy, CapEx, maintenance, etc.). This means your total expenses on the property, not including the mortgage, would be $600 per month, and your cash flow would be $600 per month, or $7,200 per year. While this isn’t a bad amount of cash flow, it represents just a 7.2% cash-on-cash ROI.
On the other hand, let’s say you bought this same property but used a 20% down payment loan, meaning you took out an $80,000 mortgage. Eighty thousand dollars at 4.5% interest for 30 years is about $400 per month. So, add that $400 to the $600 in expenses we already assumed, and you are at $1,000 per month in total expenses with the mortgage in place, leaving you with $200 per month in cash flow, or just $2,400 per year—far less, of course, than the $7,200 per year we saw with the all cash purchase.
However, $2,400 in cash flow on a $20,000 investment represents a 12.0% cash-on-cash ROI—a pretty drastic difference.
Maybe the difference between 7.2% and 12.0% doesn’t seem that drastic, but check out this chart in figure 13 that shows what a $100,000 investment, over 30 years, looks like at 7.2% and 12.0%.
Clearly, leverage can increase the ROI with the property. But is the increase worth the increased risk you are also taking? That’s a question for you to decide. So let me mention a few more possible concerns with paying all cash for a property.
How Paying All Cash Affects the 4 Basic Wealth Generators of Rentals
There are four basic wealth generators of rental properties. Those are:
- Cash Flow
- Tax Savings
- Loan Paydown
So we’ve already seen that paying all cash can help you get a higher cash flow dollar amount but potentially a lower cash-on-cash ROI. But let’s…