Today’s question is an interesting one from Jeff and it’s about financing the down payment on the purchase of a rental property. And he says, Hey, Marco, really enjoy the show. Thank you for all you do. What are your thoughts on financing? The 20% to 25% down payment to buy a rental property? In my case, I have access to $80,000 at 3.5%. And this is based on a 30-year term. I would love to hear the pros and cons. Thank you, Jeff.
Thanks for the question. It’s a good one. We get asked this from time to time. There are many people who consider this option and it actually does make sense. In some situations, it really depends on what it is you’re trying to achieve and the conditions of the investment. Now, I don’t necessarily recommend investing in properties that generate negative cashflow because then you’re putting money in every month, but there are situations where it does make sense.And we’re going to talk about that briefly here in a minute.
I want to start off by giving you an actual example, a hypothetical example, but to show you the numbers and illustrate the impact of doing this. And then from there, we can talk about, you know, when does it actually make sense to go with higher leverage or no down payment at all? So it’s really, you know, a hundred percent financing and an infinite rate of return because when you put nothing down and you have positive cash flow, your rate of return as a percentage is infinite. So if you don’t get that, maybe we need to talk. But think about that for a moment because when you put 20% down and you’re getting, you know, 8, 10, 12% cash on cash returns, but you can turn that into an infinite rate of return. There’s the given and take.
So that’s one of the pros is that essentially you’re putting in no money of your own, and you’re still getting a hundred percent of the real estate and a hundred percent of the benefits that come along with that, the equity growth, the cash flow, the tax benefits, et cetera. But you have to understand that your cash flow goes down, has your debt service goes up. So there’s a give and a take. I wouldn’t call it necessarily pro and con it’s a give and a take. Let’s talk about an example. And then let’s talk about when it makes sense to actually do this. And I’ve done this many times in the past. You just need to be sensitive about the conditions in the environment currently and going forward, because banks would refer to this as, a stress test. You have to make some assumptions that if there are going to be some hard economic times coming up and cash flows are going to scale back because maybe rents will go down in a particular market. We haven’t seen that happen in a long time, by the way, just because rental demand is so strong in many markets around the country, particularly that we’re in. But you know, you may want to just consider stress, testing your investment, pick to make sure that it will carry through for a year or a couple of years as you kind of weather through maybe some more difficult economic times.
So here’s my example. I like to use a hundred thousand dollar rental properties as the example, most of the single-family homes that we’re selling today are averaging about 125,000 median sales price, but they range from 80 to 180,000. That’s the range, but the math is easy on a $100,000 rental. Okay. So here’s the assumption. You’re purchasing a hundred thousand dollar single-family, detached rental property, a turnkey rental property. So you’re going to have an $80,000 loan if you’re doing a, um, 80% leverage, 20% down, if that $80,000 loan is at 5% interest, which is pretty typical swinging from four and a half to five and a half right now for an investment property, your monthly payment is $429 a month, and you don’t need to write down these numbers, just follow the example with me here.
So if you put the 20% down using the borrowed funds from your $80,000, and I assume that’s a line of credit or a home equity line of credit with the three and a half percent rate, which is very low, it’s a very good rate. You’re going to have a monthly interest-only payment of $58, together your total debt service is $487. Now with this example, you’re probably looking at a thousand dollars per month in gross rental income. If we make the assumption that there’s a 40% expense ratio, which is right in the ballpark, that could be anywhere from 35 to 45%. And that includes 5% for vacancy and maintenance and 5% for your vacancy allowance. And then the rest is made up of your property management for 10% and your property taxes, which is typically around 20 to 25%, but we’ll call it a 40% expense ratio. You’re going to have a net operating income of $600. So let’s take that $487 in your debt service for your mortgage. And your line of credit subtracts that four 87 from your $600 in net operating income. And it leaves you $113 per month, positive cashflow, true net-like bottom line spendable cash net, net, net.
So not bad, not huge, but keep in mind, you put a hundred percent down on this property, in the form of the purchase money. And what I mean by that, if I didn’t actually explain that properly, you finance a hundred percent of this, you borrowed 100% of the money you didn’t put actually anything down. So it’s a hundred percent financed, a hundred percent leverage, and an infinite rate of return because $113 a month, times, 12 months, what is that? It’s, you know, 12, $1,300 a year in net spendable cash. Your rate of return is infinite. It’s whatever you make divided by zero is an infinite number.
So, this does make sense in this scenario. Now, what if you put 25% down using your home equity line of credit, I’m not going to run through the numbers again, but I have them in front of me here and it doesn’t change the numbers all that much. In fact, what it does is it actually increases your monthly cash flow by $11. So now you’re at $124 per month, positive cash flow, true net bottom line, spendable cash.
So when does this actually make sense? I came up with a couple of scenarios. One is when you actually have access to the capital as you do, but you don’t actually have the extra quote-unquote funds for the down payment. Although maybe you do have the money, you don’t want to actually use it because it’s maybe just savings you don’t want to tap into or it’s emergency funds. Or maybe you’re just trying to get a jump on things and you don’t want to wait to save the money for the down payment, but you actually have the credit available to use for the down payment. So when you have no cash or little cash for the down payment, you can maybe tap some or all of the down payment from a line of credit or a home equity line of credit.
Number two in situations where you know that the rent is below fair market rent, and you have the opportunity to increase that rent maybe within the next 12 months, but in the near future to bump up that cashflow. And then you could use that to maybe put towards paying down that borrowed money that you used for the down payment. That wouldn’t be the quickest way to pay that off. I’ll tell you what that is here in a second because that segues into the third point. If you are confident about the market and the location that you are investing in with that property, it’s been showing strong appreciation in the recent past, the last one to three years and all the fundamentals and dynamics point to that investment, that market, that location to continue to appreciate pretty strongly maybe at its historic mean or above. And you feel pretty confident just based on what is going on in terms of the jobs and job growth. But more importantly is the number of people moving in, meaning that there’s strong demand and lack of supply. And that lack of supply is expected to continue. And there’s not going to be enough housing for the people moving in or the people that are already there. Then you have an interesting situation where you have really all the cards stacked in your favor and in a situation like that, you can get in and put up with the low monthly cash flow in exchange for the strong price appreciation.
Again, there’s no magic bullet or guarantee here, but let’s just say that the probability is very high. What you’re going to make in terms of equity growth from the appreciation will far surpass the loss of whatever a $100 or $150 a month that you might otherwise have with a 20 or 25% down payment. So you’re giving up on the cashflow upfront in exchange for the strong equity growth, through the expected appreciation in that property. And if that’s the case, then what you can do is within the next couple of years, maybe three years, but at some point over the next few years, you will refinance that property and you will pull out that 20,000 or $25,000 that you used as the down payment on that $100,000 rental, pay it off. Now, you don’t have that second loan, if you will, on that property. You just have a new first mortgage you’ve paid off the HELOC, and now you have the cash flow that’s just coming off of the property with that newfound equity, where you would have been as if you had the cash upfront.
So that’s where it really makes the most sense. It just allows you to get into more property, maybe quicker using the borrowed funds, but just have a plan, just know that you are going to have to be in a position in a few years to refinance and pay off that mortgage. Because if your cash flow is not high enough to pay off that loan, it’ll take you quite a while to repay it off the best way to pay it off is to just refinance it and use the equity that the new-found equity in the property as the years go by to pay off that borrowed money for your down payment. So, Jeff, thanks for the question. I hope that made sense. I’m sure it did, but just in case, let me know.
So thanks for listening. I appreciate you all. If you have a question about real estate investing or finance, just let me know, go to AskMarco.com, and just click the link at the top of the page. Thanks for listening. I will see you on the next episode.
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