Does money down really make sense in the cash flow business?

Question

I am asking this honest question as a newbie, and I hope I will get some honest replies. I don't know a whole lot about REI, so I hope someone will correct me where my thinking is wrong. I am interested in buying my first rental property but don't really see the point in putting money down on it unless I'm treating it like a bond (i.e., I intend to recoup my principal at a later date).

Just to keep the math simple, let's say I buy a multi-family property for $100k, I put $20k down and I'm able to net $500/mo from the rent. It'll be 40 months before I recoup my initial investment. It seems to me that that is a long time just to break even on my initial capital outlay.

I understand the ideas of equity and capital gain from price appreciation on the underlying asset, but just from a sheer cash in the pocket standpoint wouldn't it make more sense to try to minimize the initial out-of-pocket acquistion cost on the investment?

Again, I'm new to the financial concepts of real estate. I'm a stock investor at heart so I'm accustomed to evaluating investments from a yield on cost perspective. Thank you for your insight in advance.

Sharad M. · Answer

Hi Felix,

Welcome to BP! If you are looking to invest in Real Estate, there is no better place to learn than here.

In the example you gave about putting $20,000 down payment on a $100,000 multi-unit you are netting $500/mo. This $500/mo is $6,000 per year. $6,000 per year return on a $20,000 investment comes to 30% return on your money. That's a very good return on your money.

To answer this question, it depends on your rate of return. In the example you gave, your cash on cash on cash return is 30% (ignoring any closing cost) on an initial outlay of $20,000.

Let's say instead of investing $20,000 in this one rental property, you can invest $5,000 one rental property, but the rental property gives you net rental income of $100/mo. Your annual cash of cash return is $1,200 ($100 x 12) divided by $5,000, which comes to 24%. So in this example, you have smaller initial cash outlay, but your rate of return is also smaller than what you would have earned on the cash outlay of $20,000. You have to make your investment decision based on opportunity cost. Before you make an investment, you should look at all the alternatives for your money and should invest in the one that gives you the best rate of return.

It would make sense to minimize your initial cash outlay, but in most cases where people put down 20% on a real estate investment, it's because the banks require them to put at least 20% down. If the banks allow an investor to purchase a real estate investment with no money down, every investor would do that on a cash flow property. 20-25% is the minimum the banks require if you are financing an investment property. Instead of analyzing investments based on the least cash outlay, I look at the opportunity cost of each investment and go with the best rate of return.

Mathematically, you should invest your money where you get the best rate of return, but you should also feel comfortable with your investment choices. You should be able to understand your investment vehicles. You mentioned that you are a stock investor and feel comfortable and confident with stock investment. Let's say you can get about 28% return on your stock investment with $20,000 investment; however, with the same $20,000 you can get 30% return on your money in real estate (per the multi-unit example above), but you don't completely understand the real estate investment world. In this case, I would personally go with the lower rate of return, because I would feel comfortable with my investment decision.

BTW, the multi unit example above ignores any appreciation or debt payoff for simplicity.

It's late here when I typing this up, so I hope it makes sense.

J Scott · Answer

While I agree with all the replies above, it's worth mentioning that YES, the OP is correct that from a pure ROI standpoint, putting nothing into the investment will make for the best returns.  With not a single penny into the investment, you get infinite positive returns on every dollar you make.

Of course, with that infinite return comes some issues:

- Risk.  If the value of the underlying asset goes down even a little, you now owe more than what the asset is worth.  If for some reason you need to liquidate your holdings, you'll necessarily have to bring cash to the table or risk bankruptcy.

- Time/Effort.  Generally, 100% LTV loans (none of your own investment) return very little in terms of cash flow.  So, if you're actually trying to generate any short- or mid-term cash flow (i.e., before the asset is paid off), you may have to buy LOTS of assets using this method.  And the more real assets you own, the more time and effort goes into maintaining them.

- Difficulty.  As others here have pointed out, finding 100% LTV loans (even through seller financing) is nearly impossible in this market.

I like to think about 100% LTV financing as analogous to short selling a stock.  When you buy a stock outright (make a long purchase), you have to outlay cash.  But, that cash outlay protects you for large losses (in the case of stocks, you can't lose more than you invested).  But, when you short a stock, you don't have to lay out much (if any) cash, so you have potentially infinite gains.  But, obviously, with shorting commodities, you also have unlimited risk.

Not a perfect analogy, but you get the idea...

Bryan Hancock · Answer

Hi Felix...welcome to BP.

In general your ROE will likely be maximized by limiting your initial cash outlay.  HOWEVER, an all-cash offer in a distressed situation generally commands a bigger discount.  In some projects you will make a better IRR by using cash to get the discount at the outset and then refinancing to limit the use of your cash over the long haul.

Joel Owens · Answer

Appreciation,depreciation for taxes,cash flow,and principal pay down are the main benefits.

Also if the area was going to be bought out later for redevelopment etc. is another value play.

Everyone would like to buy no money down.

I get buyers all the time on commercial properties.They try to do the classic "can the seller take back a 15% to 20% second?"

NO!!

What the seller wants is for the buyer to have skin in the game.If they let the property go it is going to feel painful for them so they will fight through the hard times to keep the property performing.

If a seller owners finances and the buyer puts little to nothing down it can be a major mistake for a seller.

So I run into 80% pretenders and 20% REAL buyers.

There are many things to invest in you just have to know what you are doing.You can get in for less than 20% but you will be eaten up on the interest rate.

You have to find a seller in a very weak state to owner finance and agree to hardly putting anything down with a great rate.

Banks for a great rate want 25% in my area.

Account Closed · Answer

It can take time to build a rental portfolio.  There are many things to consider and I don't think that I would consider having to much  100% LTV property in my portfolio even if it was possible.

Leverage can be a very good thing but it can also seriously impact your portfolio if property values decrease.

Felix Krull · Answer

Thank you all for your replies. I appreciate your input. I am trying to learn as much as I can about real estate investing as my goal is to build a portfolio of properties and use the residual income to subsidize my monthly expenses by up to 15% in the near term and then 10 to 15 years out have my monthly portfolio income completely finance my lifestyle.

James Hiddle · Answer

Don't forget that a lot of lenders want the buyers themselves to bring skin in the game. A lot of them won't touch anything if a seller is going to do a seller carry back.

Does money down really make sense in the cash flow business?

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