I Don’t Make Down Payments … Here’s Why
Those of you who know me well know that I don’t like to bring money to closing; I’ve alluded to this fact in multiple articles here on BiggerPockets including here. Indeed, I specialize in Creative Finance and aim to achieve 100%, or as close to it as I can get on every deal that I do. There are very good reasons for this, which is the topic for today.
First, let’s establish that there are basically 3 reasons why people commonly feel that making a large down-payment is either necessary or desirable, and they are:
- Down-payment is required by the lending entity.
- Down-payment facilitates greater cash flow.
- Down-payment facilitates stronger equity position and safety.
Let me address all three…
1. Down-Payment is a Requirement of the Lending Institution
This is going to be quick – I don’t play by those rules. If a lender requires a stiff down-payment and there is no way to work around it using a blanket or some other type of cross-collateral then I move on – period. We live in a 14 trillion dollar economy plus, and if you can’t find some type of financing which is easier to accomplish than 25% down – open your eyes…
2. I Don’t Buy Cash Flow – I Create It
I hear this all the time – if the property doesn’t cash flow enough, just put more money down. What kind of backwards logic is that? As investors, we should never buy cash flow – we should create it!
First of all, in my book an acquisition needs to cash flow a bare bones minimum of $100/door under 100% financing to start with. But, even this should not be enough for you to pull the trigger. The reason real estate is so much better than stocks and other paper investments is because it comes with possibilities of expandability – things that we can do as investors to increase returns; this goes back to inefficiency of the real estate market which I discussed here. As such, you should only be buying the building if you see ways to improve that $100/door minimum cash flow to $120 – $150/door.
Now – in some markets SFR is going to represent better investment opportunities in this respect, while in other markets you are better off with multi-family. Regardless, paying for more cash flow is the absolute opposite of what you should be doing…
3. I Don’t Buy Safety – I Create It
Conventional wisdom tells us that it is not safe to finance 100% of the purchase price. After all, should the market dip this could force you to be upside down on your financing. A large down-payment is often viewed as a way to alleviate this concern, since it frees-up equity in the deal.
The counter-argument to this, however, is the notion that equity has to be bought. As a sophisticated investor, you should not be in the business of buying equity any more than buying cash flow – that’s for amateurs. You should create equity! Personally, if I ever pull the trigger on any opportunity, it is specifically because I believe that one way or the other I can force appreciation of equity, thereby creating safety quickly. Furthermore, I believe that doing things my way creates much more than just safety – it creates value.
As investors we should always be looking for ways to create value; this is why we invest after all. In the absence of opportunities to create value by forcing appreciation all that we are doing is hoping for the market to go up; that’s not investing – that’s gambling; I don’t gamble and you shouldn’t either…
Allow me to remind you that equity in the income-producing space, which is where I play, is tied to income. We buy property because it represents income streams and the more the income the more we’ll be willing to shell out for this property – basic math. With this in mind, it should be noted that if we can improve the income of the asset, more specifically the NOI, then we can create value not only on the Income & Loss Statement (Cash Flow) but also on the Balance Sheet (Equity).
Let’s say you bought an 8-plex whereby each unit rents for $500/month thus bringing in gross income of $4,000/month. Typical net operating income (NOI) in a building such as this might be $2,000/month. This means that at a CAP Rate of 10% this building would valuate at about $240,000:
VALUE = ANNUAL NOI / CAP = $24,000 / 10% = $240,000
This is what you paid – $240,000. Now – let’s say that you manage to lower the monthly costs of operating this building by $100/month, and also raise rents by $50 per unit per month. In this case you will have managed to increase the NOI by a total of $500/month ($3,600/year). In this case, the capitalized value of the revenue stream represented by this building is $60,000 more than what you started with at $300,000:
VALUE = ANNUAL NOI / CAP = $30,000 / 10% = $300,000
Thus, having paid for the building $240,000 you are now sitting on $60,000 of equity (25%) due to the increased value of your asset. And the best part of all this is that the extra $500 of NOI you’ve created flows directly into your cash flow because there are no monthly expenses associated with creating the additional revenue.
But, improving the NOI often times requires investment of capital into upgrades to physical structure and other aspects of the operations of the asset, which brings me to a question:
QUESTION: If you only have finite resources, would you rather spend your money on a down-payment, or to improve the cash-flow and grow the equity?
Most people would run out and make a $25% down-payment for this building – $60,000. If you do this, you will own $60,000 worth of equity in an un-improved building.
On the other hand, you can create the same $60,000 of equity by likely investing a fraction of $60,000 into the improvements to the building’s operations and in the process improve the NOI and Cash Flow of the asset – this ain’t rocket science guys… This is why I do not make cash down-payments; I’d rather invest my money in ways that actually create value in lieu of just buying what’s there!
Are you with me on this?