Buy less with cash or more with financing?

Question

Hi fellow BiggerPockets friends,

I’d like your opinion. If I have the means to either buy two (local) single family properties or finance more and sacrifice cash flow. What should I do?

Thanks!

Eric Yu · Answer

1 main reason I like to finance my deals is to diversify risk across multiple assets (you can even dabble into different asset classes). That said, I think it really depends on your goals into real estate. Do you have a certain cash flow per month you're looking for? A certain # of doors? What are you trying to goal on? If you know that $5k of cash flow monthly is all you need & buying 2 houses free & clear will get you there, then you might as well just go buy in all cash.

In terms of capital efficiency, let's look at an example:

Example A:

- Buy 2 houses @ $400k each. In 10 years, they're worth $500k each. Let's say each property cash flows $2,000 a month. $480k cash flow over 10 years. $800k invested, and 1.48m exit.  This is an 85% return on your money.

Example B:

- Buy 10 houses @ $400k each with 20% down on each ($80k). In 10 years, they're worth $500k each. Let's say they are cash flow neutral. Not factoring in principal pay down, $800k invested, $3.2m debt, $5m on sale. After paying off the debt, $1.8m exit. 125% return on your money.

Obviously, this is a pretty contrived example & lots of assumptions are being made, but when you put together your pro forma & model all cash vs. debt service, you should get a similar kind of result.

Hope this helps!

Zeb B. · Answer

Depends on your goals and how much time you have.

I own single family rental homes in nice neighborhoods. Not the best cash flow, but good tenants and not too many headaches. I had one house paid off and I ran the numbers on a spreadsheet to see if I should keep it with no mortgage, keep it and do a cash out refi, or sell it and use the proceeds for down payments on multiple properties.

Selling and buying several properties with financing would have been the most profitable, but it would have also required more effort up front (selling then buying/leasing several properties).

Continuing to own the property with no mortgage would have allowed me to get great cash flow, but the return on investment was low. In this case the rent is about $2,000/month, and I could have walked away with about $400,000 if I sold. Cash flow when the house was paid off was around $1700/month. Return on investment in the next year would have been whatever % the house increased in value plus the amount cashflow in the year minus any expenses/reserves I would expect to need for future capital expenses ($1700*12-$5000 saved for future capital expenses) / $400,000 = 3.8%. So if the house prices appreciated 10% in the next year, my return on investment would have been 10%+3.8% = 13.8%. Not bad but that is assuming house prices go up 10%. If house prices go up 3%, my return on investment would only be 3% + 3.8% = 6.8%.

I like to make fairly conservative estimates of home price appreciation. I look for rentals where I project about a 20% ROI if the house appreciates 3% per year. To get to 20% ROI it's helpful to have financed properties because it is easier to get 20% profit out of one house if you have a smaller amount invested. In the example above, I did a cash out refinance and pulled out $330,000. Since I could have sold the house and walked away with $400,000, I left $70,000 invested in the house when I refinanced it and took $330,000 in cash out.

Now my mortgage/taxes/insurance costs me $1900 per month, the rent is $2000 per month so my cashflow is $100 per month, and in reality my cashflow in negative if I factor in expenses including saving a few hundred dollars a month for future big expenses like the roof. On the other hand, I have $330,000 to do other things with. The return on investment for the $70,000 I still have invested in the house much is higher:

Total ROI=ROI from rent-expense+ROI from house price changes

Return on investment from rent - expenses = ($24,000/year rent * 12 - $14000 mortgage interest - $3600 taxes/insurance - $5,000 cap ex) / $70,000 invested in the house = 2%

Plus the return on investment if the house appreciates 10% ($40,000 on a $400,000 house) = 40,000/70,000 = 57% for a total ROI of 59%

Or if we assume the house appreciates 3% ($12,000) -> $12,000 / $70,000 = 17% plus the 2% ROI from the rent = 19%

In my case, I have other income sources right now and don't need the cash flow. My goal is building wealth long term. For me, keeping the $400,000 tied up owning the house free and clear and making 6.8% ROI did not seem attractive. I could probably make more money on average investing in an index fund and I wouldn't have to manage a rental.

I decided to pull cash out of the house, so I could make a higher ROI on the $70,000 I left invested in the house. I took the $330,000 and invested it elsewhere.

If you need the cash flow now because you don't have as much other income coming in, you may decide to buy fewer properties with less financing. If you don't need the monthly income now, you would probably get a better long term ROI by buying more properties with financing.

Nathan Gesner · Answer

Andrew is correct: run the numbers on both options to see what kind of return you'll get and what level of risk you prefer.

You will always get a better return when leveraging your money.

Buy one $100,000 house for $100,000 cash, you control $100,000.

Buy three $100,000 houses with $30,000 down on each, you control $300,000 and have $10,000 in reserve.

Tom O. · Answer

More doors is more money. Real simple. Leverage is your friend. Especially in times of high inflation. You save your valuable today dollars and get to repay in future more worthless dollars.

Andrew C. · Answer

run the numbers both ways <shrug>.

Don't discount the fact that having 2 is more effort/time/headache than having 1.

Joe Villeneuve · Answer

All cash just costs you more, and usually you won't recover that cost for a very, very long time...which defeats the purpose of investing.

In this case, however, your statement leads us to believe that you would be making a choice between high cost and no cash flow (maybe even negative), which is just another version of higher cost...just not paid for all at once.

If those are your two options, then there is only one choice...NEITHER.

Buy less with cash or more with financing?

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