Such was the title of a recent thread on the BiggerPockets.com Forums. I can’t help myself – let’s consider options.
But before I dig into the content, I’d like to preface this article by saying that any suggestion contained herein is more like me saying here’s what I would do with $40,000, which may or may not be the right answer for the individual who posed the question on the forum or any of your reading this.
Furthermore, while I will be using plausible examples to outline thinking which in my opinion holds merit, it must be noted that for those of you who feel the need to ask this question on a public forum, the only right answer for you is EDUCATION! For now, you need to invest into your education, not property – you are not ready for property if you need to ask this question…
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Power of Leverage
Many of you know that I specialize in creative finance methods with the aim of achieving 100% leverage whenever possible. I’ve written about it in other articles but this boils down to my belief that leverage is one of the greatest keys to unlocking the power of the real estate investment vehicle. Properly applied, leverage has the potential to amplify our investment returns and can create opportunities which may otherwise be out of reach. With this in mind, let us pencil several scenarios for deployment of $40,000 of available capital.
Single Family Dwelling for All Cash
In many parts of the county including Ohio, which is where I live and work, $40,000 easily buys a single family property which would rent for $550 per month. After deducting about $120/month for property taxes and $70/month for fire insurance, and deducting 20% ($110/month) for vacancy and repairs, a property like this will generate monthly net operating income (NOI) of roughly $250. And since there wouldn’t be a mortgage in this case, the NOI would flow through directly to Cash Flow. So, what would be the ROI on this investment in terms of Cash on Cash?
Cash on Cash = Annual Cash Flow / Invested Capital
Cash on Cash = $3,00 / $40,000 = 7.5%
This is pretty good – it certainly beats the snot out of stocks, bonds, and all the rest of the conventional investment vehicles. But, let’s take this one step further…
Pull out Cash
Let’s say that having collected two or three months of rent you go to a bank and apply for a mortgage. All things being equal, the bank agrees to leverage your house 70% LTV, and if the house appraises for the 40k that you’ve got in it (if you do things the right way it should appraise for much more), then you’ll be able to put a mortgage on this rental house in the amount of $28,000.
Naturally, this loan would necessitate a monthly payment, which at today’s rates of around 4% would be right around $135/month for a 30-year amortized note. After this mortgage payment, your cash flow would come down from $250/month to $115/month. But, you’ve just re-capitalized yourself to the tune of $28,000, which is tax-free for life since it is borrowed money 🙂
Question – Was it worth it to give up $135/month of cash flow in exchange for $28,000 of tax-free money in the bank? You are a pretty smart cookie…
And what does this do to your ROI in terms of Cash on Cash? Remember, even though your cash flow is down by $135/month, your invested capital left in the deal is now only $12,000 since you pulled the rest out:
Cash on Cash = ($115/month x 12) / $12,000 = 11.5%
For many reasons, some of which I described in other articles, I prefer investments in multi-unit space. Let us consider the impact of using the available capital to acquire a small multiplex.
In my neck of the woods, it is possible to buy a 4-plex for around $120,000. Let’s say that instead of utilizing the equity to buy a house outright, you use the money to make a down-payment on a $120,000 4-plex. You would not need the entire 40k since the 25% down-payment requirement would necessitate that you put down $30,000 in this case.
Each apartment in a building like this should rent for at least $500 per month, giving you gross revenue of $2,000. After deducting property taxes of about $300/month and fire insurance of $100/month, as well as holding back 20% for vacancy and management expenses, you would be left with a monthly NOI of $1,250.
Financing $90,000 at 4% over 30 years will cost you about $430/month. This would leave you with cash flow of $820/month, which constitutes a 33% Cash on Cash return!
Cash on Cash = ($820/month x 12) / $30,000 = 33%
I don’t know about you, but I’ll take $820/month of diversified Cash Flow any day of the week, even if I have to trade it for 30k. But those of you who know me well, know that I would get there without having to put $30,000 down…
There are many ways to play the game of real estate investing, and there are many opportunities to invest 40k. At then end of the day, though, until you KNOW what to do with the money to the point that you do not need to ask for advice, the best investment is in your education. I hope that this article serves as a step in this process…
Photo: Christopher Schoenbohm