Ratio/Percentage Rules of thumb for down payment vs cashflow
Rental Property Investor · Member since 2019 · 48 posts · 38 votes
Hey BP community,
Love this site - I've learned so much. A question since I know I've missed it...
If I pay all cash for a buy-and-hold property to achieve positive cash flow (i.e. in markets where home prices are high), is there a rule of thumb that helps determine how much down payment you should put in to achieve positive cash flow?
Theoretical example:
Let's say I buy a property somewhere for $100K cash and it rents for $1250/month, that means I paid $100k to achieve $1250/month positive cashflow (1:0.0125). If I used that same $100k to purchase 5 separate properties with 20% down on each and they individually produce $250 positive cashflow (1:0.015), is that better or worse than the previous example? Both examples produce the same cashflow overall but the latter introduces debt interest where cash isn't flowing to the investment but to a lender whereas the former does not.
Basically I can put any amount of cash towards a house and get positive cashflow but I'm not clear on whether there is a certain point where investing more cash stops being a good idea.
Does that make any sense?
//adam
I've changed my opinion on use of debt over the years (I used to dream of paying off my mortgage; now I love "leveraged real estate investing") It's not for everyone. Some folks are more risk averse and sleep better if zero mortgage.
If you buy (Plan "A") the $100k property to rent for $1250/mo....yes, you're getting 1.25% rent to purchase price ratio (very good; some of us only get half that (i.e. Denver).
Now, your choice of down payment does effect your cash flow, as you correctly say. I haven't run your numbers, but most markets (with a 1.25% ratio) will allow you to "net" about $250/month net cash flow with a 80% LTV mortgage, as you again say. So "Plan B" is $500,000 in real estate with $100,000 down.
If I do cash on one house, I say $100k invested to earn $1250/mo ($15000/yr)...this says you're still making 15% return, cash on cash. I believe there's something wrong with your assumptions.
I say this because.....to have $100k leveraged into 5 houses at 15% return (Plan B) will look better (cash on cash) than the zero leverage case. I think of that as the first $20k could have been the down payment, and achieved 15% return. The remaining $80,000 is yielding exactly the APR of your mortgage (i.e 5%/yr). So with zero leverage, you have 20% of your money at 15% and 80% of your money at 5%....so you make a combined, weighted average of 7% in Plan A.
If you happen to have $500,000 in real estate, and you experience nice appreciation....you'll also further do better with Plan B, rather than having $100,000 appreciating in Plan A. Of course, in a depreciating environment, that leverage would work against you.
Hi @Adam Peacock.
My opinion is that you would not be fully leveraging your money by leaving it all in one house.
There are a few things to consider with your example, but I think that the second scenario is better. A common goal of most investors is to find properties that appreciate in value, so let's say all of the houses in your example appreciate 3% in one year. In the scenario where you leave all of your cash in the house, you now have an additional $3,000 in equity. However, having 5 houses will leave you with an additional $15,000 in equity. If you were to compound that number over 5 years or so, your first house has is now up to almost $16,000 in equity from where you started. However, if you went the other route, you have 5 houses that appreciated to almost $16,000 in additional equity, then you've added almost $80,000 equity; the more equity you have, the more buying power/options you have.
One other thing that stands out to me is your comment about cash not flowing to the investment. I wouldn't phrase like that because it sounds like cash is flowing to the lender and not you, but that's not the case. After all, your net cash flow is $1,250 no matter which route you go in this example.
Interesting. The point about leveraging more properties to scale equity accrual is an excellent point. I'm curious is there a rule of thumb that provides a rough & loose framework that helps determine how much $$ qualifies as a good but not excessive down payment per property assuming we pursue Plan B? I can make any property cashflow with enough down payment; I admittedly still don't quite understand if a $300k home requires $100k down to achieve 1.25% rent to value - to know if tying up that much money for the return is a good idea or a bad idea. I know markets are different, not clear how much investment I should reasonably allow myself to consider in hot markets or where I like a property but a 20% down doesn't work.