Over the weekend I had a call with a family who is interested in buying a rental property from Martel Family Realty. They asked me whether they should buy this property in cash or finance it. While this is a very lengthy discussion, there are a couple of key points to keep in mind when you’re thinking about using cash or financing.
Are you Financeable?
The first thing is to look at your personal situation. I know that a lot of people buy with cash because they have no other option. These are people who don’t have W-2 income, have bad credit, or are not financeable. Therefore, the only way they can create passive income with rental properties is by using cash. However, there is one workaround to that which I have done personally.
Since I own my own business, I don’t have a very high W-2 income, so it doesn’t allow me to get conventional bank financing. What I have done in the past, and what others can do, is buy properties with cash and then do a cash-out refinance on those properties later and bundle them up together. You can do what is called a portfolio cash-out refinance commercial loan.
Local banks normally do portfolio loans, so you can reach out to them. The difference between the commercial loan and the conventional loan is that when a bank underwrites a commercial loan, they take into account the cash flow of the property heavily. Unlike a conventional loan, it’s less about you and how much money you make, it’s more about the properties, and how much cash flow they generate. In addition, make sure when you’re doing this that you use a local bank. They know the market, they know the neighborhoods and the market and the properties that are in these neighborhoods. They’ll tend to care less about you and they’ll care more about the properties and how much they’re rented out for.
Return on Investment
Let’s say that you are financeable, so you have some W-2 income, you have good or average credit, then the discussion moves more towards the returns that you would be making on rental properties. Let’s say you had $100,000 in cash and you wanted to buy a $100,000 property. That would allow you to get one property and let’s say that property cash flow is $500 a month. So from your $100,000, you would make $500 a month in net cash flow.
Let’s say then that you wanted to use financing, so you would be able to buy that $100,000 property with 20% down. With $20,000 you would be able to buy that property, and that property is going to cash flow $200 a month instead of $500 a month because you’re going to have debt service. But you would be able to buy five rental properties instead of just one rental property. So you would be making $200 a month per property, times the five rental properties that you have just bought, so you would then be cash flowing $1,000 per month.
The difference here between the returns is that if you use financing you’re able to buy five rental properties, which cash flow $200 a month, so your net cash flow for month is $1000. If you’re just using cash, then you will only be able to buy one rental property, and that property will then cash flow $500 a month. Therefore by using financial leverage and by using conventional bank financing or some other type of financing, you’re able to double your net income.
This of course is a very generic example, but with the properties that we sell all the time, this is a very basic circumstance that we often encounter with people who have $X amount of dollars in cash and want to invest in real estate. If people are financeable, we tend to recommend that they go with the financing route, just because it allows them to acquire more rental properties and also increase their net cash flow per month.
Equity and Taxes
The other benefit of using financing, is that you build equity and have many tax advantages. Using financing allows you to build equity, while buying a property with cash does not allow you to build any equity. When you’re using financing and you finance five rental properties, the tenant pays their rent, which pays for operating expenses, property management, and then it pays for debt service. And every month that the tenant pays for rent and you pay off the financing, that’s just growing your equity, that’s growing your net worth each and every month. And you’re normally going to get these properties on a 30-year fixed loan, so in 30 years you’re going to have a ton of equity in these properties since the loans will be paid off. If you’re buying five properties, each worth $100,000, that’s $500,000 of net worth that you’ve created just over time.
By buying more properties and using financing, there are also some other tax advantages that you get. You’re able to write off the interest payments. So at the end of year when you report the income for the property, you’ll be able to deduct those interest expenses. This will then show to the government that you’re making less cash flow than you actually are, because you’ll be able to write off certain things. It will also give you a lower income tax because you’ll be able to write off certain things, and there are other expenses and stuff that you can depreciate.
I am not a tax professional and this is not tax advice. Please consult a tax professional with your tax related questions.