Need advice on investment property
The Woodlands, TX · Member since 2013 · 18 posts · 29 votes
Just starting out here...
Have $50,000 to invest in real estate.
Would you:
A) Buy one Condo / Apartment outright (paid in full) and rent it out
or
B) Mortgage two Condo / Apartment's (either 15 or 30 year) and put $25,000 as a down for each
I am leaning towards the first option.
Help me understand the pro's / con's of these choices.
Thanks
Apologies for being far from an expert on this, but the conventional wisdom is that, all else being equal, more properties is the better play. In general, cash is king, and you want to use as little of it as possible to generate a positive cash flow return.
Let's look at your example, and make some assumptions, and then tack some numbers on there. We have two identical 2/1 condos, each with a 50k purchase price, where each rents for $750/month. For simplicity's sake let's ignore the soft costs like closing, title, and inspection.
Scenario 1: You spend your 50k on buying one of them outright, and your gross income is $9000/yr (750*12). Cashflow is $375/month or $4500/yr (50% rule says that half of your gross income can be expected to go towards your non-mortgage expenses, such as maintenance/vacancies/management/capex/utilities/etc). Your cash on cash return (the money you get back vs. what you put in) is $4500/$50000, or 9%. Fair, I suppose, but let's look at scenario 2.
Scenario 2: You spend 50k to put 25k down on both condos, meaning you're financing the other 50%. Your expenses are doubled (two units), but so is the rental income. The added variable is debt servicing. Again, with numbers. Gross Income is 18k/yr (2*750*12). Expenses are $9000/yr (50% rule). Leftover is profit of 9k, but you still have to pay the mortgage. I plugged financing 50k at 5.25% over 30 years into a mortgage calculator and got payments of 275/mo, which is the total debt servicing on both units. So 9k - (275*12) = $5700 yearly cashflow. Better! And your cash on cash return is 5700/50000, or 11.4%. Better there are well.
The thing to understand is that your best cashflow is going to be on a property that's paid off, but it's artificial, because you have to put more cash into it to force that return. Cash that's tied up in rentals is cash that can't be used to buy more rentals.
Suppose we take it even further (why not?!) with scenario 3: 4 condos, each listed for 50k and with that same 750/mo rent. You put 25% down on each (for a total cash outlay of that same 50k), and finance the remainder. Gross income is 36k/yr (4*750*12), and expenses are 18k/yr (50% rule). Leftover profit (called Net Operating Income) of 18k/yr. Now subtract the debt servicing (financing 150k @5.25%: $830/mo*12months= $9960/yr) and you're left with a yearly cashflow of $8040. Best yet! And your cash on cash goes to 8040/50000, or 16%!
Now, there's no question that, from a mathematical standpoint, the less you spend on a property that cash flows the better your return on investment is. But there are other expenses involved in buying multiple properties all at once, most notably the soft costs I ignored earlier (closing costs, inspections, etc). This is why people love multifamily rentals, because you get the benefit of the improved return with only one transaction.
Hope that helps!
I believe in leverage and it is one of many advantages to RE investing, thus, option b is the choice for me. In fact, I would take it further and place $15k down and buy three.
Apologies for being far from an expert on this, but the conventional wisdom is that, all else being equal, more properties is the better play. In general, cash is king, and you want to use as little of it as possible to generate a positive cash flow return.
Let's look at your example, and make some assumptions, and then tack some numbers on there. We have two identical 2/1 condos, each with a 50k purchase price, where each rents for $750/month. For simplicity's sake let's ignore the soft costs like closing, title, and inspection.
Scenario 1: You spend your 50k on buying one of them outright, and your gross income is $9000/yr (750*12). Cashflow is $375/month or $4500/yr (50% rule says that half of your gross income can be expected to go towards your non-mortgage expenses, such as maintenance/vacancies/management/capex/utilities/etc). Your cash on cash return (the money you get back vs. what you put in) is $4500/$50000, or 9%. Fair, I suppose, but let's look at scenario 2.
Scenario 2: You spend 50k to put 25k down on both condos, meaning you're financing the other 50%. Your expenses are doubled (two units), but so is the rental income. The added variable is debt servicing. Again, with numbers. Gross Income is 18k/yr (2*750*12). Expenses are $9000/yr (50% rule). Leftover is profit of 9k, but you still have to pay the mortgage. I plugged financing 50k at 5.25% over 30 years into a mortgage calculator and got payments of 275/mo, which is the total debt servicing on both units. So 9k - (275*12) = $5700 yearly cashflow. Better! And your cash on cash return is 5700/50000, or 11.4%. Better there are well.
The thing to understand is that your best cashflow is going to be on a property that's paid off, but it's artificial, because you have to put more cash into it to force that return. Cash that's tied up in rentals is cash that can't be used to buy more rentals.
Suppose we take it even further (why not?!) with scenario 3: 4 condos, each listed for 50k and with that same 750/mo rent. You put 25% down on each (for a total cash outlay of that same 50k), and finance the remainder. Gross income is 36k/yr (4*750*12), and expenses are 18k/yr (50% rule). Leftover profit (called Net Operating Income) of 18k/yr. Now subtract the debt servicing (financing 150k @5.25%: $830/mo*12months= $9960/yr) and you're left with a yearly cashflow of $8040. Best yet! And your cash on cash goes to 8040/50000, or 16%!
Now, there's no question that, from a mathematical standpoint, the less you spend on a property that cash flows the better your return on investment is. But there are other expenses involved in buying multiple properties all at once, most notably the soft costs I ignored earlier (closing costs, inspections, etc). This is why people love multifamily rentals, because you get the benefit of the improved return with only one transaction.
Hope that helps!
@JT Spangler Did bring up the fact that there are other costs beside the downpayment. What you also need to calculate into the picture is repair costs, and capex reserves.
Great input guys. Thanks much.
I am beginning to understand the benefit of leveraging. It makes sense on many levels that you have pointed out.
One curve ball here that I forgot to mention about my situation and how it needs to play out for us. We are actually going to be selling our current primary residence and moving out of state to the area that we want to invest in.
The plan is to move into a future rental property (Condo etc) for 2-3 months to get our feet on the ground in the new area and then use a zero down VA Loan to purchase a single family primary residence for us. We would then rent the original Condo of course.
So, if we take out a 30 year conventional mortgage on the Condo with say 15-25K down (rather than buying outright with cash), my only worry would be how this mortgage debt would affect the approval amount of the VA Loan we intend to use for a primary residence.
Leaning on option B. For me cash is hard to come by and its difficult to save when you are starting out.
Both option A and B are good. It depends also how long do you want to see your returns. If you go with option B and hold on to the properties for 15,25,30 years or more you have the option to see your returns in all cash (income) minus the tax\insurance\repairs or you can sell it for more on what your bought the properties for. I like the idea of using as little as cash if possible and get the two properties. But as you mentioned it depends on your personal situation.
on side note: you mentioned VA loan, thank you for your service!
Thanks Allen. :)
I always hoped that my time in the service would payoff in more than just character building. The VA Loan is GOLD.
Anyway, I am in agreement that it makes sense to use less cash upfront and have reserves for other investments. I just don't want to negatively affect our ability to get the loan amount we desire for our primary residence.
VA loans are gold.
Also good sites:
NACA, Homepath, HUD and good old realtor.com
(naca.com, homepath.com, http://portal.hud.gov/hudportal/HUD?src=/buying/loans)
I'd recommend use HUD to get into a 3 or 4 family place. Then use your VA loan on another one down the road a bit. Two tax filings from now, i.e. after you file 2015 taxes, you'll be able to use the income from the multis as actual income against a new loan.
Besides just holding onto more cash to use for other investments, are there more advantages to mortgaging a rental property rather than paying for it in full?
I remember someone saying that the tax benefits were better and that there is more protection in the event of a lawsuit when you hold a mortgage.
Actually, he did account for that since he used the 50% rule which covers cap ex! vacancies, and operating costs.
@JT Spangler - Far from an expert? Your entire post Was expert advice. Nicely done!
@Will Barnard I would disagree that the 50% rule includes capex or deferred Maint. Which as a conservative investor we would want that covered.
@Will Barnard Thanks, man! I still feel like a rookie, since analyzing the deals is a different animal then actually closing them and then living them. But one day soon!
Jeff, while you are welcome to disagree, BP has many threads specifically stating that the 50% rule covers cap ex, in fact, the only thing it does not cover is debt service.
Here is one of probably 100+ threads on the subject:
http://www.biggerpockets.com/forums/52/topics/102901-50-rule
I think you may find it difficult, or much more costly, to get a conventional mortgage for 25k, or 35k for that matter. Banks and mortgage brokers get paid on a % of the loan amount so they do not like to do the small deals (same amount of work for very little if any compensation). I had to call in some favors last year to get a 50k mortgage. That being said my vote would be option B, if you can pull off the financing piece, and if the condo has positive cash flow.
There are good reasons to use leverage in some situations but, it is not a one size fits all tool.
And using leverage ALWAYS increases your overall risk.
As to the increase in cash-on-cash returns, no one seems to take into account the effort and additional overhead expense in handling more properties.
In the example given in this thread, you have doubled your effort needed and increased your overhead expenses for a rather small increase in the cash-on-cash return of your $50K.
Extensively using leverage and adding more and more properties reaches a point of diminishing returns very quickly.
I'd love to see numbers to justify your claims @Duncan Taylor. On any of the scenarios you give there.
And how does it increase your risk?
And how does it increase your risk?
Which numbers? The ones showing the diminishing returns of ever increasing leverage? Or the ones showing a mortgage property always poses a higher risk profile when compared to a paid off property?
Both @Duncan Taylor
And how does it increase your risk?
Really? You believe a mortgaged property is less risky than a paid off property?
Well, for starters, if you have a mortgage and you have an extended vacancy, you will need reserves or other funds to cover those vacancies. That will reduce your cash-on-cash return dollar for dollar. If you don't have those reserves or other funds, you risk having the property foreclosed.
So, using leverage, you have a higher risk of being foreclosed because by definition only mortgage properties can be foreclosed. How much that increases your overall risk profile is dependent on how deep your pockets are, but as you add more and more leveraged properties the risk will increase.
You also have a higher risk of reduced returns with an extended vacancy.
The really interesting thing is if you are a buy and hold investor, and don't continually refinance to treat the properties as an ATM, the risk profile graphs between leveraged verses non-leveraged converge as the loan is paid off.
Of course, we are looking at this is isolation. There are lots and lots of variables that affect your overall risk profile. For some people, the risk introduced by leverage is the least of their concerns.
Use leverage when it makes sense. DEFINITELY use leverage if that is the only way you can get started. But, if your goal is to build generational wealth, you should always be working to reduce your overall risk profile and the amount of leverage used is a factor.
Let's make some assumptions...
Every month you have an additional $25K to invest. There are an infinite number of houses you can buy for $50K and each one will rent for $750 per month.
So, you can buy one outright every two months or you can buy one with 50% down every month.
After one year, you will have the same equity either way. Your balance sheet will look roughly the same.
Non-Leveraged:
6 houses, $300K equity, $27000 per year cash flow, total cash outlay $300K
Cash-on-Cash Return: 9%
All six of those could go vacant at the same time and you would probably be able to weather the storm without too much discomfort.
Leveraged:
12 Houses, $300K equity, $34200 per year cash flow, total cash outlay $300K
Cash-on-Cash Return: 11.4%
You have twice as many properties to oversee for a very small increase in your return %age. What's more, if you have even just a third of those have an extended vacancy you are dipping into profits, at half you are pulling money from other resources, if you have them.
If you spend just an hour each week per property you are spending 312 hours each year on your non-leveraged properties meaning you earn $86.53 per hour verses $54.81 per hour with your leveraged properties and 624 hours.
Leverage is a tool, like a hammer. But, just because you have the best darned hammer ever forged by man, doesn't make every problem or opportunity a nail.
I would say leverage all the way, except for when you said you need to get a loan for your primary residence 2-3 months after buying the rental. You would need to talk to a lender to see if you qualify for both. You could pay cash and them refinance after you buy your primary if it is iffy on qualifying.
The ash buyer has diminishing returns on vacancies as well. Just because he isn't paying a mortgage does not mean his money is getting better returns when nothing is coming in. When I run the numbers leverage wins every time as far as returns go on cash flowing property. With each property you also increase tax benefits, equity pay down and appreciation. I don't count on any of those to make money, but they are great bonuses. You said the returns converge as the loan is paid off? I would much rather have three paid off houses after the loans are paid off ten one.
When looking at your risk scenario I think the number one rule for people investing is to have reserves and emergency funds. If you are running so tight that a couple of vacant months break you, maybe you shouldn't be investing. Almost all banks will require at least 6 months reserves on each property anyway.
Except you neglect the fact that management is budgeted into the expense calculations, so whether it's 2 houses or 50 your time per week is zero.
You also do some hand-wavey math when saying, in example one, you could cover the rent for all six houses without it being an issue, but in example two covering the rent for only four (1/3 of 12) would dip into your (greater than example one's) profit. Not quite sure of the logic behind that one.
Leverage, as I understand it, is primarily about your risk tolerance. On the one hand, if you own more properties, you're more protected from a nightmare scenario at any one of them. Basically, it's a form of dollar cost averaging for owning rentals. That said, your capitals expenses can be way higher. Lots more roofs, HVAC systems, and plumbing than if you just own one property. Again, though, this expense is accounted for in the 50% rule (and, if you're actually buying, your due diligence calculations), so if you are careful with your buying you should be covered.
The argument BUT YOUR EXPENSES ARE WAY MORE! is spurious, because YOUR INCOME IS WAY MORE TOO!
It seems like where people have been burned on leverage is either (1) when the market crashes and the properties are suddenly not worth what you owe, or (2) not buying each individual property very carefully. Both of those dangers are present when you buy cash, in smaller doses. For instance, if you own a SFR free and clear and the market tanks, there may suddenly be a glut of rentals out there undercutting you, meaning you can't fill your rental. The bank doesn't take it away from you, but since there are carrying costs it's cash flow negative. If you don't come out of pocket to pay those costs you'll lose the property. If you paid cash betting on appreciation and you don't get it, same potential issue. You're stuck with a place that is costing you money. It's just less money than if you financed 10 of them. So, again, it's about risk tolerance, and (IMO) it's a difference of degree; not kind.
Unfortunately, I guarantee if we really go hard into this debate, it will get encouraged by the moderators to be moved elsewhere because it will be a huge distraction from the original post. I am more than willing to address each of your concerns, and why I disagree with them, if you want to start a separate thread. Or I'll post here if Hans thinks it would help him in his decision.
Willing to elaborate, but in short for now, I am on the extreme opposite side of this debate. I was just curious about your reasonings for your original comment in response to mine, and wanted to see if you would be able to tell me something that would convince me from my current stance. I'm sticking with my stance on leverage, which is to use it as much as possible.
Actually Ali this debate is helping me to gain a better understanding of the pros and cons of leveraging my available cash. I have not made a decision yet on what I am going to do and the more chatter I hear from both perspectives the better. Imo nothing has been off topic yet. :) Go for it
And we're more than happy to allow this 'debate' to continue, provided everyone stays professional -- no reason to stop now . . .