Many investors choose to pay all cash for an investment property. Back in 2012, BiggerPockets and Memphis Invest conducted a nationwide survey of American citizens and discovered a number of interesting facts, including that 24% of U.S. real estate investors were using 100% cash to finance their investments.
To be clear, even when investors use terms like “all cash,” the truth is, no “cash” is actually traded. In most cases, the buyer brings a check (usually certified funds, such as a bank cashier’s check) to the title company, and the title company writes a check to the seller. Other times, the money is sent via a wire transfer from the bank.
This is the easiest form of financing, because there are typically no complications, but for most investors (and probably the vast majority of new investors), all cash is not an option. However, let’s talk about this for a moment longer.
There exists a debate in the investment world about using cash for a property versus getting a loan. In one camp, you have the “no debt” people, who say a person should only invest in rental properties if they can pay all cash for the deal. The “leverage” camp responds with the math that shows that a person using leverage can obtain a much better ROI by using a loan.
The “no debt” camp fires back, “But 100% of foreclosures happen to people with debt.” And the debate rages. Who is right? If you had $100,000, would it be better to buy one house for $100,000 or five houses with a $20,000 down payment on each?
Once again, I don’t believe there is a right answer, but rather a right answer for you. In other words, what works for me might not work for you. Your decision to use debt will depend heavily on your personal finances, your goals, your age, and other key factors.
Using all cash is safer in some regards, of course. If you owned a piece of property worth $100,000 without a mortgage, you could easily sell the property if you needed to. If the property was tough to rent out, you could afford making the tax and insurance payment to keep the property floating until a renter began to pay. For simplicity, let’s say that the house rented for $1,200 per month, taxes and insurance were $200 per month, and all other expenses, over time, averaged $400 per month (repairs, vacancy, CapEx, maintenance, etc.). This means your total expenses on the property, not including the mortgage, would be $600 per month, and your cash flow would be $600 per month, or $7,200 per year. While this isn’t a bad amount of cash flow, it represents just a 7.2% cash-on-cash ROI.
On the other hand, let’s say you bought this same property but used a 20% down payment loan, meaning you took out an $80,000 mortgage. Eighty thousand dollars at 4.5% interest for 30 years is about $400 per month. So, add that $400 to the $600 in expenses we already assumed, and you are at $1,000 per month in total expenses with the mortgage in place, leaving you with $200 per month in cash flow, or just $2,400 per year—far less, of course, than the $7,200 per year we saw with the all cash purchase.
However, $2,400 in cash flow on a $20,000 investment represents a 12.0% cash-on-cash ROI—a pretty drastic difference.
Maybe the difference between 7.2% and 12.0% doesn’t seem that drastic, but check out this chart in figure 13 that shows what a $100,000 investment, over 30 years, looks like at 7.2% and 12.0%.
Clearly, leverage can increase the ROI with the property. But is the increase worth the increased risk you are also taking? That’s a question for you to decide. So let me mention a few more possible concerns with paying all cash for a property.
How Paying All Cash Affects the 4 Basic Wealth Generators of Rentals
There are four basic wealth generators of rental properties. Those are:
- Cash Flow
- Tax Savings
- Loan Paydown
So we’ve already seen that paying all cash can help you get a higher cash flow dollar amount but potentially a lower cash-on-cash ROI. But let’s look at how it affects the other three wealth generators.
The property will appreciate at the same amount whether you have a loan or not. But, again, what actually changes is the ROI. If you paid $100,000 for the property with all cash, and in one year, the property value climbs to $110,000, you have effectively increased your wealth by 10% and made $10,000 in equity. If you used that 20% down payment and only spent $20,000 on the property, and the value then climbed to $110,000, you’d have also made $10,000 in equity. But you’ve made $10,000 in equity but only invested $20,000, which means you’ve increased your wealth by 50%!
Of course, the leverage game works both ways: if the property were to decrease in value, you could be looking at a catastrophic loss in value. However, if you are following the rest of the guidelines in this book and are buying great rental property deals, and if the appreciation is only the icing on the cake, you could continue holding until the value rose again.
Although you will still get the depreciation benefit if you own a property free and clear, you will no longer be able to deduct the mortgage interest payment from your taxes, so you will likely end up paying the IRS each year on the money you make from your rental property.
In the example of the $100,000 house, with the all cash offer, the owner was clearing around $7,200 per year but can only deduct approximately $3,000 from depreciation, leaving them with a tax bill at the end of the year on their profit. However, when using leverage, the cash flow comes to only $2,400 per year after all expenses. At this point, the $3,000 deduction for depreciation would show a paper loss on the property, and no taxes would likely be due (depending on numerous factors, such as the percentage of the mortgage payment that was interest compared to principal.). Again, keep in mind that this is a very simplistic discussion on depreciation, and you should consult with a CPA for more information.
Of course, if you have no loan on the property, you have no loan paydown. You have essentially killed one of the four wealth generators. In the example of the $100,000 property, the tenant is paying off that $80,000 mortgage little by little, which increases your total return. Although you started with a mortgage of $80,000, after 10 years, you might owe only $65,000 on the property, increasing your net worth by $15,000 because your tenant paid the mortgage each month. After 30 years (or whatever loan length you used), the property is 100% paid off, and you never (hopefully) had to make that payment yourself. (Of course, you are still physically making the payment, but it’s your tenant’s rent that is covering that payment.)
Liability with Cash Offers
Finally, let’s talk about one more reason you may or may not want to use cash: liability.
When investing in real estate, there is a very good chance that someday, someone will try to sue you. When you own a property free and clear, this is typically evident on the public record, because there is no bank lien on the property. Therefore, you are essentially holding up a sign that says, “I have lots of money that you can try to take!!” If a disgruntled tenant approaches a lawyer to try to sue you, which scenario do you think will make the lawyer more excited to go after you: you have $100,000 of equity in a property or $20,000 of equity in a property? If the latter, the lawyer would understand that even if he did win the lawsuit, the most they could do is force the sale of the property, probably at a discount. After all the closing costs, there would be little or no meat left on the bone.
Therefore, lawyers (especially those paid on the outcome of a lawsuit, as most lawyers of this type are) are reluctant
to pursue rental owners who have a lot of leverage.
It may seem to you that I’m trying to influence you one way or another on using leverage, but honestly, that’s not my goal. There are more important things in life than maximizing your ROI. Security, flexibility, and the “happy wife, happy life” (or happy husband) philosophy may matter to you more than maximizing your return. Maybe that 7.2% cash-on-cash return, for example, combined with the possible appreciation on the deal, would be more than enough for you. Great! My goal in this section was to simply share with you the benefits and risks of both options.
That said, here are a couple quick tips for if you do plan to use all cash on your investment properties:
- Pretend You Aren’t: Using all cash makes people lazy. When buyers can simply write a check for a property, it’s natural not to have the same motivation to find an incredible deal. Therefore, when buying a property for all cash, pretend you are not doing so. Run the numbers as though you had to obtain 100% financing for the property. Would it still cash flow? If not, you may want to think twice about buying it. Analyze your cash-on-cash return, and make sure you aren’t using your all cash purchase to justify a bad deal.
- Use Entities Wisely: If you are going to own properties free and clear, at least try to hide the fact! Talk with your CPA and lawyer to discover the best way to hide your ownership from the public record.
- Consider Financing Later: Using all cash when making an offer can help you get better deals because sellers love cash offers. However, just because you bought a property with all cash, that doesn’t mean you have to keep it that way. You can place financing on the property after the purchase (usually 6–12 months later, depending on the bank) and start taking advantage of the benefits of using leverage. It can be the best of both worlds. And if you are concerned about the risk, also understand that the financing doesn’t need to be 80%. Maybe you want to obtain a 50% loan, or a 30% loan, or a 70% loan. The options are plentiful.
What’s your favorite way to finance properties? Have you ever used all cash for a deal?