All Cash vs. Mortgage

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All Cash vs. Mortgage

Sal G.
New York City, NY · Member since 2013 · 3 posts · 0 votes

I've signed on a $655,000 condo on the upper east side of Manhattan and we are set to close on Feb 1. Taxes, common charges and insurance will run about $1000 a month and I've found someone to rent it for $3200 a month. Currently, we've agreed to close all cash but given how low rates are (right now I have several banks offering me 4% on a 30 year fixed) I thought it might make sense to finance the property to save some money for our next acquisition (I also think that we will experience a great deal of inflation over the term of the loan, making my future payments relatively low, but that is an entirely separate can of worms).

I keep reading about how using leverage will increase my return, but every calculation I do actually shows me making a lower return on my initial investment if borrow any money. Is there something I'm missing?

Also, I don't have property two lined up yet and I will likely have to borrow to purchase it. Does it make sense just to wait until I find the next property before I put a mortgage on my first, or buy it subject to a mortgage and keep the cash on hand?

Thanks!

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J ScottPro Member
Moderator
Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
12y
Originally posted by Amit M.:
@J Scott your comments are interesting. Can you share some details on what deals went bad, like city, prop type, price? 2002 was a good time to buy (and refi 1 year later went rates hit bottom). Of course 2008 was top of the market before big crash.

Here's one example...

I rented a house in Cupertino in 2005. Landlord purchased in 2004 for $975K, and I was paying $3450 in rent. In 2008, when it was time to re-sign my lease, I was finding comparable properties for around $2500 (and value of this property dropped to about $700K). He wasn't willing to drop the rent, and I moved out. From what I later heard, I don't believe he was ever able to get it rented for what he wanted, and he went into foreclosure.

While I don't know the details of his financial situation, I presume that he couldn't handle the additional monthly holding costs given the significant drop in market rents.

Btw, that house is now worth about $1.2M according to the comps I've seen on Zillow... :-)

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  • Ugochukwu Opara
    Real Estate Agent · Philadelphia, PA · Member since 2013 · 150 posts · 59 votes
    12y

    @Sal G. I would buy it subject to the mortgage. Cash is king! Keep it with you always, And how are you running your numbers.

    Cash on cash will always be greater the less you put down. I learned that you don't want to pay all cash and for one property when you can use that cash to leverage buying 2 or 3 more. Especially when rates are at 4%. Some of the older more seasoned investors remember when the rates use to be 10% 15% 23%. Yike!

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  • Chad Ballard
    Civil Engineer · Orange County, CA · Member since 2012 · 189 posts · 45 votes
    12y

    @Sal G. , Leverage can increase your return since you have less of your own money in the deal but I would check out the beginners guide to investing. It has a lot of good info for people looking to get started. Don't forget about things like maintenance, vacancy and I always budget in a property manager even if I manage the unit myself. Also be careful about betting on appreciation didn't fair well for a lot of people a few years ago.

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  • Edward Burns
    Rockford, IL · Member since 2013 · 330 posts · 62 votes
    12y

    Without knowing your timetable for acquisition number 2 it is difficult to respond properly. If you plan on waiting a year, I would pay the cash and take out a mortgage on the first property when I got serious about looking for a second place. In the meantime save the excess rent (minus holding for major expenses). If you plan on buying property #2 in the next few months take out the mortgage now as I assume you have had an property inspection, title search etc. done and these will probably suffice for the lender avoiding these costs a second time. You should have an idea of these costs and be able to determine the break-even point.

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  • J ScottPro Member
    Moderator
    Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
    12y
    Originally posted by Sal Gambino:

    I keep reading about how using leverage will increase my return, but every calculation I do actually shows me making a lower return on my initial investment if borrow any money. Is there something I'm missing?


    If we assume your total operating expenses (including rent loss and CapEx) is 50% -- check out "the 50% rule" for more info on this -- then you COC return with a full cash purchase is just under 3%.

    If you leverage this purchase, your debt service payment will take your cash flow negative, and your returns will therefore be negative.

    Now, if you're calculating your return on equity or other metrics other than cash on cash, you may see an increased return...but your cash on cash will be lower because the leverage takes your cash flow negative.

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  • JJ GONZALEZ II
    Islip, NY · Member since 2013 · 95 posts · 27 votes
    12y

    Sal

    i would be more concerned about your return. you are putting up 655K and getting back gross 26.4k per year , in the surface this is 4%, but actually if your condo assoc decides that they need new windows and hits you with a 12,000 assessment you are screwed. You will also need to save something for repairs, and possible management fees. Even though units in nyc are selling like hotcakes, everything comes to an end. i just bought a coop (studio) for 500K

    yes folks one room 500k (but is for my kid, so all the numbers are thrown out, its not an investment, its parking money for a few years until she moves.

    good luck JJ

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  • Sal G.
    OP
    New York City, NY · Member since 2013 · 3 posts · 0 votes
    12y

    I'm calculating my ROI (admittedly, a rough tool) as (rent-expenses)/investment. Using the numbers in my first post, without a mortgage my return would be (38400-12000)/655000 = 4%. Assuming I take a small mortgage (100k at 30year fixed with 4% rate works out to be about $500 a month or $6000 a year) the calculation would be (38400-12000-6000)/555000 = 3.7%. Again, I keep hearing that leverage will up my return, but my math seems to show the opposite.

    As far as my time frame, I would like to buy within the next 6 months, but do not have any solid leads. Also, my thinking is if I take out a mortgage now I will have to pay for two mortgage closings. Why not wait until I find the property to take out the mortgage and save a bit of money doing them both at once?

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  • Michael Seeker
    Investor · Louisville, KY · Member since 2011 · 1k+ posts · 1k+ votes
    12y

    Leverage will only increase your return if the return you're getting is higher than what you're paying. If you get an 8% return and have to pay 4% for a mortgage, then leverage away. If interest rates are 12% and you only make 8%, then leveraging will lose you money.

    In your case, the return is quite low, so unless you can leverage at 1-2% (which ain't gonna happen) you're better off using cash for your CoC returns.

    Now it sounds like you're highly dependent on appreciation for this deal to work (the numbers don't make sense at all without appreciation). If that's the case, then leveraging will give you a much better return on investment than if you buy all cash. I wouldn't touch this "deal", but I'm not in the NYC market either.

    At the end of the day, you're probably better off leveraging and using the extra cash for another deal down the road. Not sure what borrowing 100K is going to do for you though if you're looking at spending $600K a pop.

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  • Michael Seeker
    Investor · Louisville, KY · Member since 2011 · 1k+ posts · 1k+ votes
    12y

    Also, just wanted to add that leverage will generally magnify your returns both positive and negative...so in general leverage is a good tool, but that assumes that you're using it for a good investment. If you use it for a poor investment then you'll be in much worse shape at the end of the day.

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  • J ScottPro Member
    Moderator
    Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
    12y
    Originally posted by Sal Gambino:
    I'm calculating my ROI (admittedly, a rough tool) as (rent-expenses)/investment. Using the numbers in my first post, without a mortgage my return would be (38400-12000)/655000 = 4%.

    The problem with those numbers is that you're going to have a LOT more expenses than just the $12,000 you're factoring in. What about maintenance, vacancy, turnover, capital expenses, legal expenses, rent loss, utilities, property management, etc?

    More likely, your expenses will be somewhere in the $15-20K per year range...

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  • Amit M.
    Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes
    12y

    @Sal G. your purchase price and returns look a lot like ours in San Francisco :) Most people on this site are cash flow investors, and don't operate in high end markets, where cash flow is not the main criteria.

    Having said that, if you pay all cash it sounds like you are not relying on the positive cash flow for your living expenses. That being the case, what I would do is leverage this unit for a loan that breaks even for you. That would be about a $400,000 loan, and will leave you +$200/month for miscellaneous expenses. In manhattan, vacancy is normally not an issue if you know your units value, and if this is a new or renovated unit, repairs will be minimal. Then take the remaining cash to buy your next unit.

    One caution about making your offer subject to loan. Since you have the cash, why not close all cash- you should be able to either get a better deal, or ensure that your offer will be accepted as it's all cash. Then as soon as you close, get your loan. You won't save much in closing costs IMO, especially not on high end props like this.

    So what has the appreciation been like in the last 12-18 months on the upper east side? Also, isn't $655k cheap for that neighborhood (is this a tiny studio)?

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  • J ScottPro Member
    Moderator
    Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
    12y
    Originally posted by Amit M.:
    @Sal G. your purchase price and returns look a lot like ours in San Francisco :) Most people on this site are cash flow investors, and don't operate in high end markets, where cash flow is not the main criteria.

    The problem is, many new investors don't perceive the risk associated with non-cash flowing properties. I was in the Bay Area back in 2002 and in 2008, and I can tell you that there were a lot of seasoned investors who lost a LOT of money because strategy of appreciation (including market rent appreciation) went the opposite direction.

    I know some newer investors who didn't have a contingency for the downturn, and who lost their properties to foreclosure...

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  • Amit M.
    Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes
    12y

    @J Scott your comments are interesting. Can you share some details on what deals went bad, like city, prop type, price? 2002 was a good time to buy (and refi 1 year later went rates hit bottom). Of course 2008 was top of the market before big crash.

    People make, and loose, money in all kinds of RE markets. But my experience has been that most who buy in the Bay Area already have a certain amount of cash to put down, so they can manage the cash flow situation. And in my case, I always buy props were I can put them to higher and better use, thus creating value by development and renovation. If you're buying retail and holding, you're more susceptible to market fluctuations. And of course there are significant variables within the Bay Area; Vallejo is a totally different story than the peninsula or SF.

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  • J ScottPro Member
    Moderator
    Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
    12y
    Originally posted by Amit M.:
    @J Scott your comments are interesting. Can you share some details on what deals went bad, like city, prop type, price? 2002 was a good time to buy (and refi 1 year later went rates hit bottom). Of course 2008 was top of the market before big crash.

    Here's one example...

    I rented a house in Cupertino in 2005. Landlord purchased in 2004 for $975K, and I was paying $3450 in rent. In 2008, when it was time to re-sign my lease, I was finding comparable properties for around $2500 (and value of this property dropped to about $700K). He wasn't willing to drop the rent, and I moved out. From what I later heard, I don't believe he was ever able to get it rented for what he wanted, and he went into foreclosure.

    While I don't know the details of his financial situation, I presume that he couldn't handle the additional monthly holding costs given the significant drop in market rents.

    Btw, that house is now worth about $1.2M according to the comps I've seen on Zillow... :-)

    Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
    1Reply
  • Jon Klaus
    Developer · Garland, TX · Member since 2008 · 8k+ posts · 4k+ votes
    12y
    Originally posted by J Scott:
    Originally posted by Amit M.:
    @J Scott your comments are interesting. Can you share some details on what deals went bad, like city, prop type, price? 2002 was a good time to buy (and refi 1 year later went rates hit bottom). Of course 2008 was top of the market before big crash.

    Here's one example...

    I rented a house in Cupertino in 2005. Landlord purchased in 2004 for $975K, and I was paying $3450 in rent. In 2008, when it was time to re-sign my lease, I was finding comparable properties for around $2500 (and value of this property dropped to about $700K). He wasn't willing to drop the rent, and I moved out. From what I later heard, I don't believe he was ever able to get it rented for what he wanted, and he went into foreclosure.

    While I don't know the details of his financial situation, I presume that he couldn't handle the additional monthly holding costs given the significant drop in market rents.

    Btw, that house is now worth about $1.2M according to the comps I've seen on Zillow... :-)

    Whip sawed. You have to plan for the bad case scenarios. When times are good, people just don't see it happening to them.

    0Reply
  • David Beard
    Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes
    12y

    This is so far to the opposite end of the spectrum from what I invest in that I barely feel qualified to even respond, LOL. However, keep in mind that without leverage you will have enough depreciation to eliminate any income tax liability. Using a loan will generate $20K+ of interest expense that you may or may not be able to deduct currently (the $25k passive loss limit phases out between $100k and $150k of gross income, unless you or spouse qualify as "real estate professional").

    On the 12k per year, did that include all of your condo association fees? I find it hard to believe that 12k could cover taxes, insurance, and condo fees on a $650k condo (totals just 2% of sales price), but once again, I don't know anything about Manhattan other than a few business trips to stay in very tiny hotel rooms.

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  • David Krulac
    Mechanicsburg, PA · Member since 2013 · 3k+ posts · 2k+ votes
    12y

    @Sal G.

    Being that the interest rate is low at 4% and that it is 30 yr fixed, and that this is your first investment, I'd say borrow as much as you can. If the bank is willing to give 80% LTV, go for it or the max. This will save a big chunk of cash for future investment and may shorten your investment time table.

    If you were already loaded down with lots of debt, or were getting much higher interest rate, or adjustable rate, or for a shorter period of time, or you were in the pre-retirement phase of your investing career, then the answer would be different.

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  • Darren SagerPro Member
    Investor · Tampa, FL · Member since 2013 · 2k+ posts · 1k+ votes
    12y

    @Sal G. First off welcome to BP! The upper east side of Manhattan is some of the most prime real estate in all of the united states. I'm not sure if you're aware of the changes that are coming that way. The city recently changed their tune and will allow a lot of new development in the area. The landscape on the upper east side will change dramatically over the next 20 years or so. Your deal sounds promising. I'm in the boat of keeping as much cash on hand as possible. Always best to be prepared.

    @Jon Klaus makes a very important point. You need to prepare for worst case scenario however upper east side is again some of the most desirable places to live in the US. There will always be demand. Where's the unit located (cross streets)? How close to subway? Close to new 2nd Ave line?

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  • Sal G.
    OP
    New York City, NY · Member since 2013 · 3 posts · 0 votes
    12y

    @Darren Sager Thanks for the feedback. I'm a new investor so I really appreciate knowing that I didn't make too big of a mistake haha.

    It's on 76th and 1st. While not on second avenue, I still think that the avenues farther east will benefit from the greater access to public transportation. What changes are you talking about? Is the city just becoming more amenable to new development in the area, or is it something more?

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  • Xing Zhu
    Durham, NC · Member since 2012 · 498 posts · 48 votes
    12y

    Leverage doesn't always increase the return.

    Leverage doesn't always magnify a positive return.

    You may find an optimal leverage for best historical return though. However, this is considered a very bad practice in security trading business as the risk there is too high. The performance (return) curve with respect to leverage often faces an abyss ahead of the optimal point mentioned above. We usually stay a distance away from such leverage point. Of course, RE investment can be quite different from security trading. The nasty shape of the performance (return) curve with respect to leverage nevertheless has a strong universality nature.

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