Many investors consider paying all cash for an investment property. And in today’s market, it may feel like everyone is paying all cash.
To be clear, even when investors use terms like “all cash,” the truth is, no “cash” is actually traded. In most cases, the buyer brings a check (usually certified funds, such as a bank cashier’s check) to the title company, and the title company writes a check to the seller. Other times, the money is sent via a wire transfer from the bank.
This is the easiest form of financing because there are typically no complications, but for most investors (and probably the vast majority of new investors) all cash is not an option. However, let’s talk about this for a moment longer.
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The great debate on paying cash for a house
There exists a debate in the investment world about using cash for a property versus getting a loan.
In one camp, there are the “no debt” people, who say a person should only invest in rental properties if they can pay all cash for the deal. The “leverage” camp responds with the math that shows that a person using leverage can obtain a much better ROI by using a loan. The “no debt” camp fires back, “But 100% of foreclosures happen to people with debt.” And the debate rages. Who is right?
If you had $100,000, would it be better to buy one house for $100,000 or five houses with a $20,000 down payment on each? Once again, there is no right answer for everyone, but rather a right answer for the particular investor. In other words, what works for one person might not work for another. An investor’s decision to use debt will depend heavily on their personal finances, goals, age, and other key factors.
An all-cash purchase is safer in some regards, of course. If a piece of property is worth $100,000 without a mortgage, the property owner could easily sell it if needed. If the property was tough to rent out, the property owner could afford to make the tax and insurance payment to keep the property floating until a renter began to pay.
For simplicity, let’s say that the house rented for $1,200 per month, taxes and insurance were $200 per month, and all other expenses, over time, averaged $400 per month (repairs, vacancy, CapEx, maintenance, etc.). This means the total expenses on the property, not including the mortgage, would be $600 per month, and the cash flow would be $600 per month or $7,200 per year. While this isn’t a bad amount of cash flow, it represents just a 7.2% cash-on-cash ROI.
On the other hand, let’s say an investor bought this same property but used a 20% down payment loan, taking out an $80,000 mortgage: $80,000 at 4.5% interest for 30 years is about $400 per month. So, add that $400 to the $600 in expenses, and it is $1,000 per month in total expenses with the mortgage in place, leaving the investor with $200 per month in cash flow, or just $2,400 per year—far less, of course, than the $7,200 per year with the all-cash purchase.
However, $2,400 in cash flow on a $20,000 investment represents a 12% cash-on-cash ROI—a pretty drastic difference.
The pros of paying all cash
You’ve seen an example of paying all cash versus using a loan, but let’s talk about the pros of the all cash offer.
An all-cash offer with proof of funds has fewer stumbling blocks since the transaction is only between the buyer and seller. When a buyer offers to pay cash, they could move in within days of closing the deal since they do not need 30 or 60 days to close. With this fast closing, the seller doesn’t have to wait long at all to get paid.
A contingency is a clause in the contract that defines a condition or action that must be met for the sales contract to become binding. Both parties, the buyer and the seller, must agree to the terms and sign the sales contract, contingencies included, to become binding.
These added clauses enable the investor to acquire property on their terms and provides a way out of the contract if things go south. An all-cash offer, on the other hand, immediately removes the financing contingency and, most of the time, the appraisal contingency.
Potential price discount
Paying all cash may lead to a discount since the seller does not have to wait for an appraisal and mortgage loan approval. Sellers may be inclined to give a cash discount because they are saving on closing costs since they do not have to worry about a loan origination fee or discount points.
Save on mortgage interest and PMI
PMI stands for private mortgage insurance. Lenders require homeowners to get this when they purchase a house and put down less than 20%. It is a monthly fee added to mortgage payments.
The cost of PMI varies based on the price of the property purchased. Depending on the investor’s credit score and their risk profile to the lender, they will pay between 0.5%–1% of the loan amount in PMI per year.
Here is an example:
If a property is purchased for $315,000 with 5% down, the total loan amount would be about $300,000. Therefore, the PMI would be $3,000 per year or $250 per month.
Aside from the PMI savings, all-cash purchases save on mortgage interest. Mortgages can be quite expensive after repaying the actual cost of the home with additional interest. This can mean a difference of thousands of dollars over the life of the loan. Plus, the interest rate depends on the type of loan or mortgage—at times this can even double the cost of the home.
The cons of paying all cash
Now that we’ve discussed the pros, it’s time to dive into the cons.
Tying up your money
The biggest downside of paying all cash is that all the money is tied up in that property and investors lose liquidity. Keep in mind that having a cushion of cash for emergencies will be invaluable when unexpected repairs crop up.
Losing out on better investments
When an investor takes out a loan and only pays for the down payment, there is money left over to invest in other properties. If any other investment opportunities come up, the property owner will not be able to use their money for those more lucrative investments.
It takes longer to save up
The other thing to consider is time: It will take a longer time to reach homeownership since all the money has to be saved first. And for those that bought a property all cash, it will take time for them to save up money for any new investments.
Other home-buying expenses paying all cash won’t avoid
Just because you pay all cash for a house, it doesn’t mean all your expenses disappear. Yes, you don’t have to worry about a mortgage, but there are other expenses you will be responsible for as a homeowner.
Property taxes are part of the deal and will have to be paid no matter what. The seller’s real estate agent should be able to provide a copy of the property’s tax bill. Check out the city or county website of the property to get an idea of the property tax that needs to be paid—and if a hike is coming up.
If the jurisdiction charges 0.5% of the assessed value annually and the property was bought for $200,000, then expect to pay $1,000 in property taxes.
Homeowners insurance is a form of property insurance that covers losses and damages to an individual house along with assets in the home. While carrying this type of insurance is an investment MUST (consider it as the first line of asset protection defense), if a loan is used to buy the property, having homeowners insurance becomes a requirement.
Utilities and maintenance
It goes without saying that any utilities—gas, water, internet, cable, trash, and sewer—will have to be paid. And expect the unexpected! Things will break so some money will have to be put aside for unexpected repairs and maintenance.
If the property is in a community or building with a homeowners association, there will be corresponding monthly or annual dues to pay. The fee depends on the property and the amenities available and can cost a couple of hundred dollars.
All-cash offers and the four basic rental wealth generators
There are four basic wealth generators of rental properties, which are:
1. Cash flow
As discussed earlier, paying all cash can help achieve a higher cash flow dollar amount but potentially a lower cash-on-cash ROI.
The property will appreciate at the same amount whether it was purchased with cash or with a loan. But, again, what actually changes is the ROI. If the property was bought with cash for $100,000 and in one year the property value climbs to $110,000, it effectively increases the property owner’s wealth by 10%, making $10,000 in home equity. If a 20% down payment was used and the investor only spent $20,000 on the property with the value climbing to $110,000, they would have also made $10,000 in equity. But they made $10,000 in equity and only invested $20,000, which means they have increased their wealth by 50%!
Of course, the leverage game works both ways: If the property were to decrease in value, the investor could be looking at a catastrophic loss in value. However, if they are buying great rental property deals—and if the appreciation is only the icing on the cake—then they could continue holding onto the property until the value rose again.
3. Tax savings
There are several tax deductions available to property owners. Although they can still get a standard deduction like the depreciation benefit if they own a property free and clear, they will no longer be able to use the mortgage interest payment as a tax-deductible. So, they will likely end up paying the IRS each year on the money they make from their rental property.
In the example of the $100,000 house, with the all-cash offer, the owner clears around $7,200 per year but can only deduct about $3,000 from depreciation, leaving them with a tax bill at the end of the year on their profit. However, when using leverage, the cash flow comes to only $2,400 per year after all expenses. At this point, the $3,000 deduction for depreciation would show a paper loss on the property, and no taxes would likely be due (depending on numerous factors, such as the percentage of the mortgage payment that was interest compared to principal). Again, keep in mind that this is a very simplistic discussion on depreciation, and investors should consult with a CPA for more information.
4. Loan paydown
Of course, if there is no loan on the property, there is no loan paydown, essentially killing one of the four wealth generators. In the example of the $100,000 property, the tenant is paying off that $80,000 mortgage little by little, which increases the total return.
Although the investors started with a mortgage of $80,000, after 10 years, they might owe only $65,000 on the property, increasing their net worth by $15,000 because their tenant paid the mortgage each month. After 30 years (or whatever the loan length), the property is 100% paid off and the investor never (hopefully) had to use their money to make that payment. (Of course, they are still physically making the payment, but it’s the tenant’s rent that is covering that payment.)
Liability with cash offers
Finally, let’s talk about one more reason an investor may or may not want to use cash: liability.
When investing in real estate, there is a good chance that someday, someone will try to sue the property owner for their assets. When the property is owned free and clear, this is typically evident on the public record because there is no bank lien on the property. Therefore, it is essentially like holding up a sign that says, “I have lots of money. Come and take it!”
If a disgruntled tenant approaches a lawyer to try to sue, which scenario will make the lawyer more excited to go after the property owner’s assets: the asset with $100,000 of equity in a property or $20,000 of equity in a property? If the latter, the lawyer would understand that even if he did win the lawsuit, the most they could do is force the sale of the property— probably at a discount. After all the closing costs, there would be little or no meat left on the bone. Therefore, lawyers (especially those paid on the outcome of a lawsuit, as most lawyers of this type are) are reluctant to pursue rental owners who have a lot of leverage.
There are more important things in life than maximizing an ROI. Security and flexibility may matter more than maximizing a return. Maybe that 7.2% cash-on-cash return, for example, combined with the possible appreciation on the deal, would be more than enough for an investor. Great! The goal of this section was to simply share the benefits and risks of both options.
Tips for buying in cash
If you’re determined to pay cash for a house, here are some guidelines to follow.
Pretend it isn’t an all-cash offer
Sometimes all-cash transactions make people lazy. When buyers can simply write a check for a property, it’s natural not to have the same motivation to find an incredible deal. Therefore, when buying a property for all cash, pretend not to. Run the numbers as though a loan was obtained to finance the property. Would it still cash flow? Analyze the cash-on-cash return, and make sure that an all-cash purchase isn’t used to justify a bad deal.
Use entities wisely
Talk to a CPA and lawyer to discover the best way to hide ownership from the public record. If a buyer is going to own properties free and clear, at least try to hide the fact!
Consider financing later
Using all cash when making an offer can help get better deals because sellers love cash offers. However, just because a property is bought with all cash, that doesn’t mean it has to be kept that way. Financing can be done on the asset after the purchase (usually six to 12 months later, depending on the bank) and owners can start taking advantage of the benefits of using leverage. It can be the best of both worlds. And for concerns about the risk, understand that the financing doesn’t need to be 80%. It can be a 50% loan, or a 30% loan, or a 70% loan—the options are plentiful!
Paying cash for a house may be tempting, if you have the funds to support it. But there are a number of reasons it’s not a great idea. Make sure to consider the pros and cons before tying up your fungible cash in real estate.
Learn more about paying cash
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
Source link: https://www.biggerpockets.com/blog/all-cash by Brandon Turner at www.biggerpockets.com