Which gives higher returns all cash or financed?

Question

Say there's a property and it is the same price whether all-cash or financed. It is the lower end of prices at $50k, which will give higher returns and be the better decision? Why?

Michael Smith · Answer

Hi @Therese V. first let me say that whether or not to use leverage (debt) when purchasing real estate is a personal decision, and what is better for one person may not be better for another, based on their goals and level of risk aversion.

That being said, leverage is used to MAGNIFY returns. That means if returns are positive, leverage will allow you to get a higher rate of return. But when returns are negative, leverage will cause your rate of return to be even worse. Your degree of leverage will determine how sensitive your change in net profit or cash flow are to annual changes in net operating income.

Let's look at an example of a $50,000 property.

If purchased with all cash, lets say your initial investment is $50,000 (ignoring closing costs and such for simplicity). Let's assume that this property will rent for $1,000 per month so the gross potential income for the year would be $12,000. Using the 50% rule to account for expected vacancy, taxes, incurance, property management, maintenance, repairs, and capital expenditures... the net operating income ends up being $6,000. That gives you a 12% cash on cash return ($6,000 divided by $50,000).

Now, lets say another investor decides to use leverage to purchase the house next door. He puts 20% down, so his initial investment is only $10,000 (again ignoring closing costs for simplicity). Let's say he finances the remaining $40,000 with a 30 year fixed-rate mortgage at 5% so the monthly P&I (principal and interest) payments are $214.73 (I'm leaving out taxes and insurance which would normally be escrowed because those expenses come out before NOI and do not change based on your decision to buy with cash or leverage). So this property bring in the same $12,000 GPI and has the same $6,000 NOI after using the 50% rule. But this investor also pays $2,576.76 per year for P&I debt service so his cash flow is only $3,423.24... That gives you a 34.23% cash on cash return ($3,423.24 divided by $10,000).

Leverage sounds great right? Well look at what happens when the unexpected happens and our NOI changes due to actual expenses being either higher or lower than our estimates.

First lets assume that our NOI goes UP because our expenses were lower than projected. If our actual NOI ends up being $7,000 for the year, both investors see an extra $1,000 cash flow.

The investor who paid in cash with $50,000 has $7,000 in cash flow and sees an annual return of 14% (2% more than our prediction of 12%).

The investor who only put $10,000 down has $4,423.24 cash flow after his mortgage payments, and sees an annual return of 44.23% (a whole 10% more than our prediction of 34.23%!)

But now let's assume that our NOI goes way DOWN because our expenses were higher than we projected. Suppose that one year we have a lot of extra repairs and expenses, or a much longer vacancy than normal, and our NOI ends up being only $3,000.

The investor who paid in cash with $50,000 has $3,000 in cash flow and sees an annual return of 6% (6% less than our prediction of 12%).

The investor who only put $10,000 down has a cash flow of only $423.24 after his mortgage payments, and sees an annual return of only 4.23% (30% less than our prediction of 34.23% and even less than the cash investor's return).

So you see that leverage magnifies your return based on changes in NOI and can be either very good or very bad. If you have the cash reserves to hang on during the rough years, and your long-term NOI is high enough than leverage can be a great tool to help you get much higher returns than would otherwise be possible.

I personally have decided to use leverage in my business, but I do very carefully and with much planning. Hope this helps, and good luck! Sorry for the long post but I felt it was necessary to truly answer your question =]

Michael Smith · Answer

@Therese V. I'm also looking to buy-and-hold for the long-term, and personally I'm jumping at the opportunity to lock in long-term fixed-rate mortgages at these historically low rates.

If you take your time evaluating deals and proceed with caution, this method of building a RE portfolio can provide an excellent way to build wealth and cash flow for the long haul.

And when deciding whether or not to pay down debt on a fixed-rate mortgage, remember that your rate of return is your interest rate and you should evaluate your opportunity costs. So if you are not overleveraged and you can earn a higher return by purchasing an additional property or through some other investment, paying down debt might not be your best option. For example if you have a 5% interest rate on a mortgage and you are deciding where to deploy capital, think of debt paydown as a guaranteed 5% rate of return.

Michael Smith · Answer

Sara McGrath explain how he tries to use 100% financing while still capturing equity. The key is to find a good enough deal.

For example, if you can find a motivated seller willing to sell you a property for $40,000 that needs $10,000 worth of repairs but the ARV will be $100,000 you've definitely got a deal. You can finance 100% of the purchase and repairs (total of $50,000) but the actual value of the property once all repairs are completed is $100,000 so you managed to capture 50%, or $50,000 worth of equity.

This scenario is the best of both worlds, because you get the security of having equity in the property while using maximum leverage to allow higher returns!

Michael Smith · Answer

You bet!

Charlie Miller · Answer

Good to know thank you!

Michael Smith · Answer

@Charlie Miller there are still lenders here in Florida willing to lend on an investment condo, they just typically require an audit of the HOA to show solvency and competency of handling funds.

Charlie Miller · Answer

One advantage to cash is you're in a stronger position to buy the property.  Sellers like cash buyers.

As of a few months ago, banks wouldn't even offer financing for investment condo's in Florida (due to "housing crisis" and potential of HOA fees rising with so many owners not paying).  Not sure if this is changed..

Great responses in here!

Therese V. · Answer

Thanks for mentioning also paying down the mortgage is the rate of return. When looking at it that way and the low interest rates we can get at the moment, it really seems that leverage is the way to go right now.

I'm glad I asked the question, because the area I am looking has such low priced housing I couldn't figure out if it's better to get a mortgage or just pay cash. Although, I still need to look around to see where I can get such low mortgages, but that's a different issue.

Marcus Johnson · Answer

If your referring to me, thanks for your data input which I enjoyed reading.   Just an FYI, I already understand the differences between the two, I was commending Michael for the way he presented his material on the topic.  His writing skills are quite good.

N.A N.A · Answer

With higher risk, there's higher return.

Assume you have 50k, and you have the following 2 options:

1. Purchase a small property at 50k in city X.

OR

2. Purchase a property at 200k with 25% down which is your 50K in city X.

When market raises, all properties in city X raise in its value by 10%.

Your property raise 5k from option 1, and your property raise 20k from option 2. (Cut all the property taxes and sales tax out as we are giving generic numbers), your return from option 1 is 10%, and your return for option 2 is 40%.

As mentioned, with higher risk, there's higher return.

When market falls, all properties in city X reduces its value by 10%

your property reduces 5k from option 1, and your property reduces 20k from option 2.

Your loss for option 1 is just 10%, while your loss for option 2 is 40%.

Do these generic numbers help?

Which gives higher returns all cash or financed?

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