Not every real estate investor can afford to buy in cash. And even those who have the cash on hand often opt to finance their investment properties, rather than coughing up hundreds of thousands of dollars in cash.
Why? What are the advantages and disadvantages of financing investment properties, rather than buying in cash?
Whether you have the option to buy in cash or not, make sure you understand the pros and cons of financing – and how it affects your long-term risks and returns.
Advantages to Financing Investment Properties
People love to say “cash is king” in the real estate investing world.
But the simple fact is that financing your real estate investments comes with plenty of its own perks. If you’re planning to finance your next rental property, milk the following advantages for all they’re worth!
Imagine you have $100,000 to invest in real estate. Assuming you have access to investment property loans requiring a 20% down payment, you have a choice: you can either buy one $100,000 property in cash or five $100,000 properties with 20% ($20,000) down on each.
Spreading that $100,000 across five properties reduces your risk through diversification. You put those 100,000 eggs in five baskets rather than one.
Because even when you do your proper due diligence to avoid buying a bad investment property, things can still go wrong. Six months after buying, the local town could decide to build a highway right next to your property. You could lease to a deadbeat tenant who causes immense damage to your property. The list goes on.
2. Faster Scaling
Similarly, you can buy more properties faster when you finance them. When you buy with a loan and put down 20%, that means scaling your real estate portfolio at five times the speed of cash buyers.
Even when you take out a loan, you still get all the benefits that come with investment property ownership. You get the tax benefits, the appreciation, and of course income from each property.
Advantages that expand alongside the size of your portfolio.
3. Better Liquidity
Real estate is notoriously illiquid, meaning it’s difficult to convert to cash (liquid capital).
An investor who buys a $100,000 investment property with cash effectively locks that money up in the property. They have only two options to access it: take on debt or sell the property. Both of which cost significant time and money.
Contrast that with a real estate investor who puts only $20,000 of their full $100,000 in a property, by financing the other $80,000. They still own the property, but they’ve only locked $20,000 up in it. And they still have the other $80,000 in cash to do with as they please, such as investing elsewhere (such as stocks or other investment properties), to put toward their retirement or children’s education, or simply to stay available for unforeseen expenses.
The more liquid your assets, the more flexible your money, and the more options you have.
4. Inflation Works in Your Favor
Say you take out a 30-year investment property loan, with a monthly payment of $500. In 25 years, that monthly mortgage payment will still be $500. Which will, at that time, be worth far less than it is today.
Yet your rents will be significantly higher. You can raise rents each year to keep pace with inflation. In fact, rents rise even faster than inflation in most markets.
So every year that goes by, the spread between your rent and your fixed monthly mortgage payment increases at a faster pace than inflation alone does.
Consider a quick example. You pay $500/month on your mortgage, and the property rents for $1,000 in the first year you buy it. When that lease is up, you raise the rent by 3%, or $30.
The spread between the rent and the mortgage payment rises from $500 to $530: a 6% increase. Even though you only raised the rent by 3%, your profit potential rises by 6%. And over time, that only accelerates, as those increments start to compound on themselves, even as your mortgage expense remains fixed.
5. Leverage Amplifies Your Returns
Again, you buy a $100,000 property. The market rent is $1,100, and the non-mortgage expenses come to $450 per month. If you buy this property in cash, your monthly cash flow comes to $650 per month or $7,800 per year. On a $100,000 cash investment, that means a 7.8% return on your cash – a solid, if not extraordinary return.
Alternatively, you take out a 30-year investment property loan at 5% interest, for $80,000. That puts your monthly payment (principal and interest) at $429.46. Your monthly cash flow drops to $220.54, for an annual cash flow of $2,646.48.
But since you only invested $20,000 of cash, that means you’re earning a far better 13.2% return on that cash.
Keep in mind leverage cuts the other way, too. If you buy a property with negative cash flow, leverage makes it worse, amplifying your monthly losses.
6. Tax Advantages
While sometimes overstated, mortgages do come with tax advantages for investors.
Landlords can deduct mortgage interest on all rental property loans, and they don’t have to itemize their personal deductions to do it. Beyond the interest, investors can also deduct other loan-related costs like lender fees at closing.
The ability to deduct the expenses doesn’t negate them entirely, but it does reduce their impact on your bottom line. If you pay $5,000 in mortgage interest in a year, but deducting that cost saves you $2,000 in taxes, then your real cost is only $3,000.
Advantages to Buying Investment Properties with Cash
Buying property with cash comes with its own benefits, most of them more straightforward than the benefits of financing with an investment property loan.
If you have the cash available, consider these advantages before jumping straight to a loan.
1. No Risk of the Deal Falling Apart Due to Financing
If you need a loan to close the deal, and that loan falls through, you lose the deal.
But when you buy with cash, you control the money. You don’t have to worry about underwriting and last-minute delays or demands from lenders. You just show up with a certified check and close the deal.
That’s particularly useful when you buy a property at auction. If your financing falls through at an auction, you lose your deposit, with no contingency options in place.
2. Better Negotiating Position
Sellers love the sound of “cash offer.” It removes all their concerns about the deal falling apart due to financing, too.
In fact, many sellers are willing to accept a significantly lower price from cash buyers, for two reasons. First, cash buyers can settle faster, which is music to the ears of most sellers. And, of course, sellers get far more certainty that the contract will actually settle.
Cash buyers can often secure better deals because they have so much more negotiating power.
3. No Lender Fees at Settlement
Lender fees add up, usually to thousands of dollars. Most lenders charge two types of fees at closing: a percentage-based “origination fee” (better known as points), and flat “junk fees.”
Both add up quickly. Two points on a $200,000 loan come to $4,000. And lenders love to hit all borrowers with flat junk fees, making up names like “processing fee” and “underwriting fee” and “document preparation fee” and “wire transfer fee.” It all amounts to the same thing: fees the lender charges you because they can.
4. No Interest
Interest adds up to a shocking amount of money, spread over the entire life of the loan. If you take out an $80,000 mortgage at 6% interest for 30 years, you pay more in interest ($92,670.40) the loan amount.
Avoiding that interest leaves far more money in your pocket.
5. Better Cash Flow, Less Labor
No monthly payment means better monthly cash flow, of course. Which sounds obvious, and it is, but it ties in a related point: you don’t need to do as much work to bring in the same net cash flow.
Imagine you’re preparing to retire, and you have ten rental properties, each with a loan against it. They bring in $3,000 per month in net cash flow.
You could keep managing the ten properties in retirement, earning the $3,000/month. Or you could sell seven of them to cash out the equity and pay off the remaining three in full. Which leaves you with the exact same $3,000 per month in cash flow.
So, instead of managing ten properties to earn $3,000/month, you only have to manage three. Less work, for the same income.
6. No Risk of Properties Falling Underwater
A property becomes “underwater” on the mortgage when the property is worth less than the loan amount. The higher the percentage of the purchase price that you borrow with a loan, the greater the risk of falling underwater if the market downshifts.
When you buy in cash, you don’t face that risk. At all.
Should you take out an investment property loan for each home you buy? Or should you save up more money and buy in cash?
It depends on your goals, your risk tolerance, and where you are in your life. Buying in cash provides lower risk, but far slower acquisition.
For younger and middle-aged adults with plenty of time left in their careers, I recommend using leverage to build a portfolio of investment properties. Your tenants can pay down your mortgages for you, while you enjoy the cash flow, appreciation, and tax benefits.
At a certain age, however, it starts making more sense to pay down any remaining mortgages. Your risk tolerance decreases as you approach retirement, and the less debt you have upon retiring, the less risk you face from vacancies and turnovers.
Build a portfolio in your younger years. Let it appreciate and grow. Then consolidate it in your older years.
How do you pay for your rental properties? Has your strategy changed at all over time? If you finance your properties, who do you use for investment property loans?
This article has been contributed by G. Brian Davis.