Put down additional 5% for 8% cash on cash return?!?!?

Question

Hey guys! Looking for some opinions here. I’m buying a SFR to rent out to college students in my area. This house is going to be a solid money maker, on a low end looking at 30% cash on cash return, and as high as 45% on the high end.

However my business partner and I are arguing whether we should put down 20% vs 25%, and we could use some input to help us decide. Here are the numbers:

Purchase Price: $289k

@20% down ($57,800) - Mortgage $231,200 @ 5.5% interest, P&I payment = $1313/mo

@25% down ($72,250) - $216,750 @ 5.375%, P&I payment = $1214/mo

So, if we put down the 25%, we’re putting down an additional $14,450 to make our mortgage payment $99/mo cheaper - that’s $1,180/year. So as I see it, $1,180 in addition cash flow on a mere $14,450 additional money down  = 8.2% cash on cash return just by putting down some extra $$.

Granted I’m not accounting for the potential tax benefits of that additional mortgage interest if we opt for the 20% down, but as I see it we could get an additional 8% ROI by throwing down a bigger down payment. I used to be under the mindset that it was best to buy with minimal down payment, as it boosts the overall cash on cash return. However money isn’t as cheap as it has been the last few years and as interest rates have crept up, I’ve encountered this conundrum. Help!!

Also to add, we are fortunate that neither of us is cash poor right now. My partner thinks we should save the money and put it towards the next deal, because we can do better than 8%. However with the prices high and interest rates going higher, I’m not confident in our ability to find another deal so easily. It’s taken us >1yr to actually get a deal under contract that made sense like this one, so otherwise my money will just sit in it’s Capital One money market account And earn a measly 2%. OR I could throw it down on this house and get an easy 8% ROI without any additional work! If there were a bank accout that did that, who would turn it down??? Am I right??? Or sorely wrong???

Thoughts?????

Ned Carey · Answer

@Gregory Bertoncini

Something to think about is that money today is still well below long term norms. Today is still cheap money.

So you are getting a 25%+ return on $57k. Why would you even consider investing another $14,500 for only an 8% return.

I wouldn't invest my money in real estate for only an 8% return.

Justin F. · Answer

To build on what @Bill F. said, the first example is called accretive debt, where it enhances your net return, while the second case is called dilutive. I.e. If your loan constant is below your cap rate, it is accretive.

There is more to this which OP alluded to, if your constraints are time, energy, or deal flow- then it can make solid sense to put more equity to work at lower debt levels.

E.g. Imagine you own 50% equity/debt in a $30M long owned multifamily, and manage one property manager/property, and spend the rest of the time with your family (or your family of yachts) enjoying your amazing life with your $1.5M return, or can own 25% equity in two deals, and spend twice as much time on problems but make $2.25M, or you can own 5% equity in 10 deals, and spend 10x as much time on problems- for a $3.25M return. Hopefully just hire more staff at that point and try to reduce some headaches, but it would still be more work than just your one property.

Gregory Bertoncini · Answer

Thank you for the reply Ned! I agree, I wouldn’t go and buy a deal that would only net 8% return. However what I’m taking about here is just putting down an extra 5% on this deal for a marginal rate or return of 8% on that additional 5% down payment. It’s like putting money in a bank that gives you 8% interest. Given the scarcity of deals near me, it’s not like I’ll be able to just put that money towards another deal tomorrow’s for a 25%+ ROI, so I figured in this way it’s working for me for 8% ROI without me needing to do any additional work.

James Ma · Answer

cash is typically king in freedom and flexibility to take advantage of buying opportunities so I always go with 20% down to keep my options open. Most mortgages will allow you to paydown 10% remaining balance a year so you can always do that if you changed your mind. The only other consideration that comes to mind is if your debt is too high to get another property then a higher downpayment can help you pick up the next property anyway

Michael Ablan · Answer

@Gregory Bertoncini  -  Will you be planning to purchase any more properties after this one?  If so, how soon?  Do you have the funds for the down payment now?  Will you be short?

For me, my main concern is, Do I have enough cash to fund the down payment for my next deal?  Putting down anything more than the bare minimum takes away the cash I need for my next deal.  The only way I get closer to goals is by buying more rentals, so the choice is easy...for my situation.

If this is going to be your last purchase for the foreseeable future, and you're business plan is to make some good monthly cash flow, while paying off the mortgage ASAP, then yes, putting more down is probably the right move.  Just depends on your goals.

Good luck!

Bill F. · Answer

@Gregory Bertoncini can't give an accurate answer with the info provided. We'd need to see the overall Income and Expenses to help you out.

It is an axiomatic statement that if you put a higher down payment your cash flow will increase.

It is important to see what impact going 25% instead of 20% will have on your overall free cash flow and marginal return.

Say at 20% down the property cash flows $1/yr. The CoC is .0017%. Up the down payment to 25% the cash flow is now $1,189 with a CoC of 1.6%. That's a good investment.

However if the cash flow is $12k/yr @ 20% down, the CoC is 20.7%. Going to 25% down yields a Cash flow of $13,188, but a CoC of 18.3%. In that case, the extra 5% isn't a great investment.

That tells us that somewhere in this simple example between $1 and $12,000/ yr of cash flow the return of one more dollar invested (marginal return) goes from positive to negative. If you want to optimize solely CoC, you'll need to find that point.

Mike Dymski · Answer

The return is not 8.2%...it's the interest rate on the loan.  For example, if the property was purchased for all cash, the owner would save the interest rate on the loan...not a rate higher than that...and it does not change with the level of the down payment.

Paying down a fixed rate 5.5% loan versus investing the funds in a 2.0% savings account would net 3.5% savings (and it would occur in a rising rate environment).

Ned Carey · Answer

@Gregory Bertoncini that makes sense. You seem to be  well aware of the trade off you are making, which is a good thing. It's just not the choice I would take.

Put down additional 5% for 8% cash on cash return?!?!?

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