How much money does it take to invest in rental properties?
Probably not as much as you think.
In the history of the world, perhaps nothing has killed more real estate ambitions than the belief that one does not have enough money to get started.
In fact, I speak with people all the time who don’t know it’s even possible to invest in real estate without having the full 100% purchase price of a property. They look at a $200,000 property and try to do the math in their head, thinking, “Well, if I saved $200 per month from my job, I could start investing 83 years from now. But that’s never going to happen, so I guess investing in real estate is only for the privileged rich.”
(P.S. This is unrelated, but FYI – last Thursday night I did a webinar here on BiggerPockets about Analyzing Rentals that had over 2,000 LIVE attendees. If you missed it, don’t worry: I’ve put the replay up until Monday night, so if you want to check it out, do so this weekend before it’s gone. Click here to check out the replay! Or to sign up for THIS week’s LIVE webinar, visit BiggerPockets.com/webinar)
Using Leverage to Reduce the Amount of Money You Need to Invest in Real Estate
While yes, it is true that some investors pay for properties in all cash, the majority of investors utilize leverage when buying rental properties.
Leverage is a term that simply means applying a small amount of force to achieve far greater results.
With real estate, leverage usually comes in the form of loans. A small down payment is supplied by the borrower, a lender provides the remaining balance of the purchase price, and you pay that lender a small amount each month until the loan is paid off.
For example, I might look at that same $200,000 property but get a bank to lend me 80% of it. They would supply a $160,000 loan, and I would need to only come up with the $40,000 down payment (plus closing costs, which we’ll cover in a moment.)
Now, I only need to save up $40,000 instead of $200,000.
Yes, I need to pay the bank each month for many years, but hopefully I’ve done my math right and I’m making far more income than I’m spending on that loan payment.
Of course, saving $200 a month (as I mentioned earlier) would still take many years to save up that $40,000. However, there are other strategies for using even more leverage or finding lower priced properties. (Like you’d hear about if you picked up a copy of The Book on Investing in Real Estate with No (and Low) Money Down.)
Yes, this is pretty basic stuff but you might be surprised at how many newbies fail to realize that this is how the game is played.
The Dark Side of Leverage
Leverage, of course, can be both a blessing and a curse.
The more leverage you use, the greater risk you may be placing yourself in.
For example, if you paid 100% cash for a property, you wouldn’t have a loan payment due each month, so a three month vacancy on your property wouldn’t hurt as bad. Or if you bought a house with just 5% down, and the value of that property dropped 20%, you are now “underwater” and owe more money on the house than it’s worth.
This limits your future options and can make it difficult to sell, refinance, or do much of anything with the property.
This leveraging is what caused much of the housing collapse and glut of foreclosures in the market in 2007 and 2008. Homeowner Hank purchased a home for $100,000 and used 100% financing, putting down $0 on the property. When the value of that property dropped to $80,000 and Homeowner Hank lost his job, he couldn’t sell the property because he owed far more than what he could get. The bank needed $100,000 to be satisfied, and the most he could get is $80,000. As a result, Homeowner Hank and millions of others simply allowed the bank to foreclose and take back the house.
So, was leverage to blame?
Should we NOT pay 100% for rental properties?
What is the magic number?
I’d like to reframe the question and force you to think about it in a little bit different light. Rather than discussing how much to put down, I like to think “How secure can I be?”
Two Important Truths About Risk
There are ways to increase your security when using leverage, so let me cover the two main points.
First, the down payment is not as important as the deal you get. If you purchase a house for $100,000 and put 30% down (thus obtaining a $70,000 loan) and I buy an identical house for $70,000 with 0% down (thus obtaining a $70,000 loan), who is at more risk?
I’d argue that YOU are at the greater risk because you have more cash invested, but our loan amounts are identical. I just did the upfront work required to pay $70,000 and you didn’t. I leveraged my creativity in place of a down payment.
Secondly, when investing in rental properties, knowledge can help decrease the risk of leverage. The better you understand the market, your investment and how to manage that investment, the lower risk you have of something going wrong.
For example, if you do the math correctly before buying an investment property and you know that you need to account for the property sitting empty a certain percent of the year, then that vacancy, when it occurs, won’t sting. It’s just part of the business. Your knowledge helped secure the investment against the things that WILL go wrong.
For this reason, we built the BiggerPockets Property Analysis Tools to help you run the numbers on any potential deal, to help you avoid buying bad deals and focus on the good ones.
How Much Money Should You Put Down?
So, perhaps you can see now why I can’t simply give you a clear answer to the question, “How much money does it take to invest in rental properties?”
However, I don’t want you leaving this post without having a good number in your head, so let me offer two of the most common scenarios:
If you plan to purchase and live in a small multifamily property between two and four units, you could obtain a bank loan for as low as 3.5% down through the FHA loan program. This concept, known as “House Hacking,” is a great strategy for those just starting out with real estate and have limited cash and experience.
However, again, you are required to live in the property (for at least one year). Also, when using a low-down loan like the FHA, know that there is an additional fee charged to the borrower each month known as PMI that can increase your loan payment by around $100 per $100,000 financed, so just be sure to include that in your math.
(For more on House Hacking, see “How to Hack Your Housing and Get Paid to Live For Free.”)
Most banks want a 20% down payment, at minimum, for rental properties. There are a number of banks which will allow less, such as 10%, and some banks will require more, such as 25% or even 30%. Each bank will have their own requirements, but as of the date of this writing, it should be possible to obtain financing for around 20%, as long as you qualify.
(For more info on qualifying for loans, see “Confessions of an Ex-Banker: How to Get Your Next Loan Approved, Guaranteed.”)
Much of the discussion in the real estate community revolves around 20% down payments, as the norm for planning and strategizing for the future. This is definitely the most common, but please understand that the dollar amount or down payment percentage is not as important as the concepts that lie below the surface.
If you want to read everything I know about investing with creativity, don’t miss my first book, The Book on Investing in Real Estate with No (and Low) Money Down available on Amazon or at BiggerPockets.com/nomoney.
I have no problem with people who want to use 100% financing on their real estate. I am a big fan of the personal finance advice given by Dave Ramsey, who is a staunch advocate for paying only 100% cash for all investment properties.
However, I also recognize that for many, myself included, waiting to invest until I have all the cash needed would require decades of sitting on the sidelines.
If you decide to invest with all cash, I would caution you to pretend that you were not when shopping for deals.
Having excess money when shopping is dangerous, whether you are in Nordstroms, the supermarket, or looking for rental properties.
Being able to pay all cash allows people to be “soft” on the math and pay too much for the property because it’s easier to just write the check than it is to find a great deal. Know your numbers, scrutinize the property carefully, and be sure it provides a solid return on investment.
What About Reserves?
This post has focused primarily on the down payment needed to invest in rental properties. However, there is another purpose for your cash… and that is for reserves.
The fact is, when investing in rental properties, things will go wrong. You’ll have good months, bad months, and average months — and you never know what you are going to get. This is why it’s imperative that you have cash reserves to cover any problems you might face.
It would be terrible to buy a rental property and, in the first month, be forced to evict a tenant and make thousands of dollars in repairs, but this kind of thing could happen.
The amount of cash you should have in reserves depends on a number of factors, most notably the number of properties you own, the condition/age of those properties, how much it would cost to fix the property up (will you be doing the work yourself?) and your management abilities.
I would encourage you to start with six months of expenses per unit you have. For example, if you have a single family home that costs you $800 per month in expenses, I would recommend having $4,800 in savings for that property. As you get more and more properties, you may be able to decrease this amount, but it’s a good starting point.
So how much money should you have to get started investing in rentals?
You tell me.
Leave your comments below.
I’d love to know how much YOU think you should have to get started!