Buying Properties For Cash Can Be BIG Mistake – A Hugely Expensive Mistake

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One of my favorite conversations is with real estate investors sportin’ lots of capital who insist on paying cash for investment properties. They’re almost universally flabbergasted when I tell them they can do better in today’s environment by using a bit of leverage. When they ask me to prove it, I begin by asking them a couple questions.

Is the cash on cash return of their acquisitions important to them?

Are they investing so they’ll have future retirement income?

If their answer is yes to both, I then proceed to demonstrate — empirically — exactly how the ‘always pay cash’ strategy will sometimes produce significantly inferior results. Let’s be clear about how we’re defining results here.

The successful attainment of maximum retirement income through a strategy created to use the finite capital immediately available at any given time.

An investor has half a million bucks to invest with the above mentioned agenda in mind. His plan is to retire in 15 years — at which time he’ll be 65 years old. He finds a couple duplexes for $250,000 apiece. They’ll generate roughly $36,000 a year in income. (For the purpose of this post, we’ll use just the purchase price without closing costs to keep things simple.) They’re well located, new or newer, and have a strong demonstrated track record attracting quality tenants.

He’s excited. I tell him to look at what’s possible if he were to use a slightly different strategy. Rolling his eyes, he agrees. What could possibly beat the return provided by paying cash?

Let’s establish his cash on cash return generated by his all cash approach.

That return is calculated simply — divide cash flow by cash invested. In this example it’s $36,000/$500,000 = 7.2% — pretty straightforward.

But what if he puts 1/3 down payments on six of these duplexes? Today’s available financing allows him to obtain 30 year fixed rate loans sporting 5% interest. Let’s see what his cash on cash return would be.

$43,580/$500,000 = 8.7% cash on cash return. Don’t miss the fact that the cash flow in dollars has increased by $7,580 annually — a 21% increase in cash flow from Day 1.

He’s not rolling his eyes any more. 🙂

By using what I’ve come to call the Domino Approach, he’ll have used the cash flow from all properties to pay off one duplex at a time. It’ll take almost 3.5 years to free and clear the first property, but then he begins realizing the immediately increased cash flow and the velocity increases as each domino falls.

In less than 13 years — 12 years, eight months — he’ll be the proud owner of half a dozen debt free income properties. They’ll be spinning off about $108,000 in annual retirement income — well over two years before his scheduled retirement.

He’s also retiring with triple the income his plan would’ve produced.

I pointed out that in the process his actual cash flow and cash on cash return were much higher than if he’d applied his approach — from beginning to end.

It’s important to note that the NOI (net operating income) and the property values were not projected to increase — ever. Yet, look what also happened to his capital growth rate — then compare it to how his capital would have grow in his ‘all cash’ scenario.

In Year-0 he invested $500,000. 12.67 years later his equity was $1.5 Million. His capital growth rate was just under 9% (8.96%) Again, no appreciation was applied.

His way?

Year-0 — the same $500,000 invested. 12.67 years later his equity is the same $500,000. He literally has no capital growth. In fact, it can be credibly argued he lost money due to inflation.

Forget cash on cash — forget capital growth — just concentrate on the difference in retirement income he generates from each of the two strategies.

$36,000 as a result of paying all cash — $108,000 as a result of using moderate leverage.

It’s at this point I ask them to put me on speaker, and stand up. Then I tell ’em to extend their arms straight out, palms up, as if they were weighing different objects in each hand. Then to move each hand slightly up and down, as if determining which object is heavier. When they tell me they’re doing that, I recite the following, not making any effort to hide my glee. 🙂

“I dunno, $36,000…..$108,000 — which one do I want? That’s a poser.”

I won’t repeat what many of ’em reply to that. 🙂

BawldGuy Takeaway: When it’s possible to make use of positive leverage, i.e., the cost of borrowed money is less than your investment’s return, paying all cash is the inferior strategy. This is true for cash flow, cash on cash return, and the ultimate cash flow generated long term.

Paying cash for income property isn’t the slam dunk no-brainer so many folks think it is. Sadly, most of ’em won’t figure this out ’till they retire — if ever.

The most underrated task in the investment world is solid analysis. You can pay for it before you invest– or pay for it afterward, which will be the rest of your life.

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

21 Comments

  1. Another Investor on

    And those of us paying cash today for good deals because a) it’s the only way to get the deal done and/or b) we are locked out of the mortgage market because of silly government regulations fully intend to leverage out and acquire more properties when the opportunity presents itself.

  2. Other investor, your loan doesn’t have to come from the bank. I understand that challenge very well. There are plenty of private lenders (folks with money in their RRSP or IRA that would happily make money like the bank does and give you a mortgage or just people with cash looking for a secured return). Also some home sellers might be willing to do a VTB …

    There are ways to use leverage even without a bank involved in the deal. And really, that’s my number one reason to buy real estate. Where else can I invest $10,000 to control something worth 10x’s or more than that amount??

    Great post Jeff!!

  3. Let me play the ‘devil’s advocate’ here. As someone who has paid MORE than $500,000 in cash for properties this year alone, there are a few reasons to pay cash.

    First off, you stated “Year-0 — the same $500,000 invested. 12.67 years later his equity is the same $500,000. He literally has no capital growth. In fact, it can be credibly argued he lost money due to inflation.” If there is INFLATION, then the value of the property goes up (over all). Overall, property out paces inflation, over time. Maybe not the last 3 years, but the last 30 years, most definetly.

    Next, you are assuming that rent is always paid. Anyone with any experience can tell you that that is not always the case. A duplex in a nice area now may become a bad area in 3 years. If you need rent to make the mortgage payment and no rent comes in, you could lose your entire investment (see today’s foreclosure rates).

    While leverage is a viable investment strategy, there are hundreds of thousands of property owners whose “leverage strategy” cost them everything. You buy a $100,000 house and put $10,000 down. If it goes up $10,000, you double your money. If the value drops 10%, you lose everything BEFORE the bank loses anything. If you need the rent to make the payment, you have more risk.

    Due to the uncertainty of today’s market, a portfolio of 50% ‘free and clear’ properties and 50% ‘fully leveraged’ properties makes more sense.

    One very huge advantage to ‘free and clear’ properties? You can sell it and be the bank yourself, getting 30 years of mortgage payments for retirement and have no property management headaches.

    A very good article, explaining the advantages of leverage. But you seem to down play the risks.

    Mike

  4. Hey Mike — Thanks for the comment. You’ve got a few things skewed though, about where I come from I mean.

    I agree with your basic approach of having a solid mix of leverage/F&C. It’s not for everyone, but you and I are singing the same song there.

    In the post’s example, though I didn’t ‘show my work’, the strategy used resulted in a free and clear property in, as the post said, just 41 months. I’d think you might applaud that. In just eight years, half of ’em were indeed debt free — your approach in a nutshell, but a small difference in timing.

    The inflation point you brought up is well made. We both remember, at least I’m old enough to, that the 70’s had double digit inflation. Yet, real estate in San Diego, arguably one of the markets benefitting most from appreciation the last four decades, couldn’t, in the end, keep up. Inflation won. Still, I get your point. It becomes moot though, in that my results in the post are so superior to buying for cash — only those extremely risk averse would eschew that approach out of hand.

    If an experienced investor can’t tell if an area is gonna be that bad in just three years? They haven’t learned much — IMHO. Been doin’ this since Nixon’s first year in office, and I’m sorry, but transitions don’t happen over night. Pros can see them coming before they hit the horizon. Folks who get caught in those kinda situations suffer because they bought the price and not the other longer term factors. Low price fixation has been the ruin of many, I’m sure you’ll agree.

    Rent is NOT always paid, buy location quality and the quality of tenants said location attracts will tend to mediate down times. An example? Property in certain areas of TX have not only seen a decrease in vacancy factor, but a simultaneous rise in rents. Go figure. It’s about expertise and experience. In my example, if rents fell by as much as 25% the property would still be paying for itself.

    Leverage and bad experience? You bet. But comparing my scenario with an example using 10% down is comparing apples to dead fish. 🙂 I had the investor putting more than triple that amount down. That argument is hollow, though a solid Devil’s Advocate position. Though again, I agree with you in as much as it relates to silly, super low down payments.

    Frankly, Mike, I think we pretty much agree in concept on most things. That said, and given the fact my example used 1/3 down payments, long term fixed (low) rate loans, and a strategy of quickly ending up free and clear — some of your conclusions don’t seem totally on target.

    You make an excellent Devil’s Advocate. Please — don’t be a stranger.

  5. Jeff,
    I have run the math and leverage is better, but in your calculations why don’t you assume the free reinvests 100% of that 36k like the leverage scenario?

    Also in your scenarios do you ever encourage clients to keep some money back and pay down the mortgage after they get it. In order to shift that amortization table to the right?

    Loving the purposeful plan posts. Please keep em up.

    Jason

  6. Jeff
    I bought my first rental when Reagan was in office, not Nixon (LOL). I am seriously thinking about buying a couple more rentals this year, using 50% down. This “splits the difference” between fully leveraged and fully free and clear. You have a very small payment and with cheap money. But it is easier to make the payment when a property is vacant, as mortgage reserve requirements are less. I just get upset when a novice investor buys with “no money down” and then finds the rent doesn’t even cover the payment or one major repair eats up six months rent. Investors need to understand that while leverage is a good strategy, too much leverage creates too much risk.

    Again, good article.

    Mike

  7. I’ve done that before. The determining factor, Jason, is how long it takes to save enough for down/closing for the next property. Then you’d hafta compare the chronology of the two strategies — how long would it take for the guy doing it the way you suggest to put six debt free duplexes in the barn? My guess, and I’ll do the numbers myself and get back to ya, is that it’ll be WAY longer than most might suspect.

    That said, I’ve had to wipe egg off my face due to analytical results more than once. 🙂

  8. Hey Mike — Beginning to think we may be brothers from other mothers. 🙂

    The 0% down crowd, for the most part, find themselves on the receiving end of pretty swift justice, something you and I have witnessed ad nauseam. Pros can do it, but even they find themselves on the wrong end of the Karma spear.

  9. In your example you have an interest rate below the capitalization rate of the investment. Any time this is case you will always improve cash on cash return by leveraging as much as possible, in this case 100% if you could. Leverage is a great tool for maximizing rate of return but you absolutely must not leverage past the bottom of the market if you plan to stay in the investment long term. Otherwise you risk losing the entire investment. Applying a 50% leveraged / 50% non-leveraged approach only achieves the same as “diversifying” with stocks/bonds/et cetera. You cannot lose everything but you also cannot gain everything. The best way to avoid the risk that I see is to study your market, in its entirety, as well as you can as real estate is local and is interconnected with the local economy, and acquire properties at the bottom or as close to it as possible. Patience is the key. Only make a purchase if it meets your requirements and never to just stay fully invested.

  10. Jeff,

    You have been licensed since before I was born! LOL 1974

    I think just like anything strategies vary for each individual investor on what they want.

    You inserted a way to make 1.5 million off of 500k in about 13 years. Not a bad return but I am seeing much greater returns for investors.In Atlanta for instance you can acquire 60 unit apartments for 5,000 a door and then you need 5,000 a door for rehab.

    So to get into rentable shape you are looking at a 600k investment.The 60 unit 2 bedroom you can rent for 575 a month.

    Of course you would forecast capital expenditures into the offer price.

    575 X 60 = 34,500 month
    34,500 X 12 = 414,000 gross income
    30% O and E
    5% property management
    15% vacancy

    414,000 divided by 2 = 207,000

    207,000 at a 10 CAP = 2,070,000 sales price on a 2 year selling horizon

    Based on this scenario you can scale up the returns to much greater than 1.5 in year 13. I guess it just depends on the investors level of involvement and their goals.

    These are the type of value add deals I am seeing investors go after.If I had 500k I would want to grow it to substantial amounts and have a mix of long term holds and then shorter term value adds.

    You have way more experience than me but I talk to about 50 investors a week and this seems to be what most are targeting currently in my market.I just have much more upside with larger properties than owning a bunch of little duplexes.

    I do have one investor that like to buy all cash and he is a multi millionaire so I don’t question him. other investors like joint venture arrangements where they can leverage capital.Another investor like to buy distressed land as he owns about 20 businesses and doesn’t want to manage or think about another property.So I guess it’s like people’s tax situation in that everyone is different. I love these discussions as we all learn so much. 🙂

  11. Hey Jason — The post needs to be taken in context. When dealing with those who insist on buying all cash, the approach I offered, though pretty tame, tends to stretch the cash buyer’s comfort zone a bit. 🙂 Also, my strategy uses leverage more ‘daring’ than 50% down. 🙂

    Tellin’ folks to study the market is investing 101 to be sure. But tellin’ an all cash investor to more or less go ‘all in’ just ain’t gonna get traction. They simply don’t think in those terms.

  12. Joel — Been there, done that. The two observations I’d offer:

    1. Most investors who’re putting 0-10% down, do so due to lack of financial choice, ignorance, or both. The exceptions, the real pros, are few and far between, making that approach work consistently. Even they’ll tell ya, they have battle scars. 🙂

    2. The only way anyone is buying apartments for $5,000 a door is if they have an AK-47 in order to enter/exit the neighborhood. I’ll pass.

  13. I’d LOVE to find 5% 30 year mortgages on investment properties. I’m hitting a dead end so far — My best to date is 20 year / 3/3 ARM @ 5% negligible (<$500) closing costs, no appraisals. I've talked to all the local banks, and for a few grand, I can lock in rates as low as the high sixes for TEN years ….. Any chance of you booting me in the right direction…? Thanks! And thanks for your contribution and for setting a great example of thorough thinking vs. following the herd.

  14. hello everyone,

    I am a 1st time investor in rental property and have a couple questions. I’m looking at buying a small house right now that I can get for about 50k which will need improvements of about 25k before it’s up to code and suitable for renting.

    My big question is: I already have the $75k to buy the property outright, but would it make more sense for me to use $30k of that money and get a secured CD loan off it? That way the renter would essentially be paying off that portion of my investment. So basically after 5 years the renter would have created $30k in equity for me and I would then be able to get my $30k cd back from the bank and re-use it for my next property?

    any advice is appreciated! TIA

    Derrick

  15. Jeff
    I noticed “30 year financing @ 5%” — Can you give us a hint where financing of this nature for non owner occ. properties can be found? I would pay dearly for this, but haven’t found anything remotely resembling these terms. My secondary bank just offered me 20 year term, 10 year locking for 7% or 7 year lock in for 6.25% (25% down). My current loans are all 5.25% adjustable every 3 years with 2% point limit each 3 years.

    The thing I’m most curious about even is the 30 year term period. Does this really exist? I’ve just never been able to find that long a term at ANY interest rate but it would a great diversifier. Thanks for any help. Sorry we never connected. I still have your number~!

  16. Hey Ken — Go to my blog, BawldGuy Talking — (bawldguy.com). Scroll down till you get to a mortgage update written by Chad Emerson. He’s my lender, who, in the last couple weeks or so has locked in several clients at 4.875% fix rate loans — 30 years. 🙂 Click on his name next to the ‘written by’ and give him a call. Tell him I sent ya.

    And if we ever meet, Ken, you’re buyin’. 🙂

  17. Jeff,

    I used to buy all of my properties 100% cash out of my pocket. Then I ran out of money!
    When that happened it also opened my eyes to what an idiot I was. In this market buying 100% financed is much safer. If the SH fan I will loose nothing, if the area hits the skids I will loose nothing, if the opposite of all the bad things happen I will profit. I have mitigated my risk on the new 100% financed properties to zero.

    So I agree paying 100% cash is a mistake, how may properties can I buy with 100% financing?

    I will admit these deals do not come around on a regular basis, but they do come around a couple a year. With no risk on my end, do I really need huge cash flow? I have huge cash flow on the ones I paid cash for and now cannot sell. I want my sellers to be the bank, but I do not at this time want to be a banker.

    I believe Warren Buffet when asked recently what he thought to be a great investment, said buying nice single houses with low fixed financing for 30 years. He figures with the coming possibly massive inflation these houses will be paid off with devalued dollars. I remember my father telling me his $25,000 1955 mortgage with a payment of $150 was a burden to pay when he was first married, 20 years later even with 7 children the $150 seemed like nothing.

    If you are old enough (55) $100 seems like it has about $20 worth of purchasing power.
    I would assume between the recent mad printing of the dollar, a $100 will soon seem like todays $5 bill.

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