Be a Smart Investor... Do the Math
by Bill Bronchick
Should I use cash or credit? ARM loan or fixed rate? Ten percent down or twenty
percent? Should I pay down debt or keep a cash reserve? These are all good
questions, and here's some of the answers.
Cash vs. Credit: The Concept of Leverage
In order to understand real estate financing, it is important that you
understand the time value of money. Because of inflation, a dollar today is
generally worth less in the future. Thus, while real estate values may increase,
an all-cash purchase may not be economically feasible, since the investor’s cash
may be utilized in more effective ways. Leverage is the concept of using
borrowed money to make a return on an investment. Let’s say you bought a house
using all of your cash for $100,000. If the property were to increase in value
10% over 12 months, it would now be worth $110,000. Your return on investment
would 10% annually (of course, you would actually net less, since you would
incur costs in selling the property).
If you purchased a property using $10,000 of your own cash and $90,000 in
borrowed money, a 10% increase in value would still result in $10,000 of
increased equity, but your return on cash is 100% ($10,000 investment yielding
$20,000 in equity). Of course, the borrowed money isn’t free; you would have to
incur loan costs and interest payments in borrowing money. However, you could
also rent the property in the meantime, which would offset the interest expense
of the loan.
Taking leverage a step further, you could purchase ten properties with 10% down
and 90% financing. If you could rent these properties for breakeven cash flow,
you would have a very large nest egg in 20 years when the properties are paid
off. Balance that with what you could make by investing the cash flow on one
free and clear property for 20 years. And, of course, look at the potential risk
of negative cash flow from repairs and vacancies on ten properties. Finally,
consider the tax implications - if you have cash flow, you have taxable income;
if you have increase in equity, there's no tax until you sell.
Cash Flow vs. Cash Reserve
On a similar note, the size of your down payment will affect your cash flow on
rental properties. Let's consider two examples.
Example 1: $100,000 property with $20,000 down. $80,000 loan @ 6%
interest, including taxes and insurance is about $600/month. Assuming you could
rent the property for $800/month, you have $200/month cash flow or $2,400/year.
Not bad.
Example 2: $100,000 with no money down. $100,000 loan @ 8% (higher rate is
generally common for zero-down loans) would make your payments closer to
$900/month. With zero down, you have $100/month negative cash flow.
Which is better? Well, it depends on what your goals are and what the rest of
your financial picture looks like. Let's say your goal was to hold the property
for 10 years. In the first example, you have $200/month cash flow, but no cash
reserve. In the second example, you would have $100/month negative cash flow,
but you have $20,000 in reserve. The knee-jerk reaction of some people is that
example #1 is safer. But is it really?
Think about it... in the first example, if your property becomes vacant for one
month, you'd be out of pocket $600. It would take three months to make that up.
In the second example, you have $20,000 in cash cushion to make up the deficit.
With $20,000 in the bank, you could handle $1200/year negative cash flow for 16
years. If the property were in an appreciating market, you'd come out fine, even
with negative cash flow. Another factor is the choice of loan. You could buy a
property with nothing down and an interest-only loan fixed at 5% for three
years. If your exit strategy is a lease/option that should cash you out within
36 months, why do a fixed-rate loan?
The point here is that you should not automatically go with a fixed-rate loan.
Nor should you seek positive cash flow as the only goal. Likewise, you should
not buy properties with nothing down and negative cash flow and assume that
short-term market appreciation will be the only source of your profit.
Paying Down Debt
For years, our parent's generation discouraged debt as a "bad" thing. For some
investors, the goal is to own properties “free and clear,” that is, with no
mortgage debt. While this is a worthy goal, it does not always make financial
sense. If you have free and clear properties, you will make certain amount of
cash flow and pay a certain amount of income tax. If you need more cash, you are
forced to sell the asset, creating a taxable gain.
If you refinance a property, there's no taxable event. And, since mortgage
interest is a deductible expense, the investor does better tax wise by saving
his cash. Think about it... the higher the monthly mortgage payment, the less
cash flow, the less taxable income each year. While positive cash flow is
desirable, it does not necessarily mean that a property is more profitable
because it has more cash flow. More equity will obviously increase monthly cash
flow, but it is not always the best use of your money. On the other hand, paying
down debt may make sense if you can't get a higher return elsewhere in the
market. Also, if paying down debt can have other rewards, such as bringing a
loan below 80% LTV, you may be able to cancel private mortgage insurance and
save additional money.
In Short, Don't Rely on Assumptions... Do the Math!
Bio:
William Bronchick, CEO of Legalwiz Publications, is a Nationally-known attorney,
author, entrepreneur and speaker. Mr. Bronchick has been practicing law and real
estate since 1990, having been involved in over 600 transactions. He has
appeared as a guest on numerous radio and television talk shows including CNBC
Power Lunch. He has been featured in Who's Who in American Business, Money
Magazine, the Los Angeles Times and the Denver Business Journal. William
Bronchick has served as President of the Colorado Association of Real Estate
Investors since 1996.