Hello my friends. Welcome back to Passive Real Estate Investing where we dive into the world of real estate investing among other related topics. To help you with your real estate investing journey, today we’re doing something a little different. We’re going to take a trip down memory lane and showcase an important episode from the past on what we call our throwback Thursday episode. Now, whether you’ve been with us since the beginning, which goes back to 2015, or you’re tuning in for the first time, this episode is a must listen, we are revisiting one of our more popular episodes from the past, and believe me, what we discussed back then, whether it’s six months ago or six years ago, is just as relevant today. So sit back, relax, and let’s rewind the clock for this great episode. Enjoy.
Hello my friends and welcome to another episode of Ask Marco where I answer your investing related questions.The question here is an Ask Marco question submitted by someone by the name of Conrado. I hope I pronounced that correctly, but because it’s such an in-depth question, I wanted to expand on it.
Conrado writes in and he says, hi, Marco. Loved the podcast. Very informative with the right level of information, especially for investors starting like me, my situation is the following. I’m looking to buy my first investment property soon, looking to deploy $200,000 of my portfolio to start investing in real estate. My goal is to reach 10 units in 10 years, buying one per year. That’s a great goal.
My question is, should I buy cash to get the better price upfront and refinance this first property when you’re from now to raise cash for the second one or should I finance this first one with 20% down and save the cash to finance the second one year from now? I feel like if I buy cash I could get a better deal in this case. How easy is it to refinance to raise cash one year from now to buy the second one? Thanks and great job with the podcast.
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Throwback Thursday Episode (The episode originally took place in the year 2020)
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Okay, so thanks for the questions Conrado this is a very good question and I think a lot of people think about this because when you talk about buying a property all-cash, a lot of people are under the belief falsely or otherwise that you can get a better price or a better deal if you come to the seller with an all-cash offer. And so let’s define that for those people who don’t understand what all cash means.
An all-cash deal or an all-cash offer is one where you are purchasing without financing, meaning the seller is getting all cash from you, not from a lending institution.
So look at this way. Regardless of whether you’re financing a property or not, the seller is always going to end up getting quote-unquote all cash because the funds are coming from one or more places, but at the end of the day, their proceeds from that sale is going to be all cash. They don’t really care where the financing or funds come from, although they might care if it’s being financed because that typically takes a little bit longer from your perspective. You’re either coming to the table, the closing table with a down payment, a percentage of the purchase price or 100% of the purchase price. And if you’re purchasing with 100% of the purchase price, that’s typically what they refer to as all cash. Now, why would you want to purchase all cash? The idea is is that if you come to the closing table or approach a seller saying, Hey, I’m going to purchase your property all cash and you think you’re going to get a better price, that may be true, but a better price typically comes from two main situations or conditions.
One is when you are in a buyer’s market, which we are not in today, we are in predominantly a seller’s market right across the country in virtually all markets and that means the sellers have the upper hand. They know that demand is strong and buying activity is strong. Credit is widely available and it’s relatively cheap, so there’s more demand for the property than there are sellers to fulfill the demand that’s created by the buyers in the market right now. The other situation is when you are dealing with a motivated seller, if you are talking to a motivated seller, someone who is having a hard time selling their property or their property has been on the market for a long period of time or they’re in an area that it’s making it difficult for them to sell the property, then you might have some leverage on the seller and may be able to convince them, telling them that, yeah, I can provide all cash and help you sell your property.
So the idea is that one, you can close faster with an all-cash offer. Two is that you’re more likely to close the transaction. Them dealing with a buyer that is coming to the table with a down payment and financing through a lending institution because that’s going to be a longer sales cycle. There’s an appraisal involved, there’s the risk of the appraisal coming in low and you ultimately not qualifying for the financing at the end of the day. At the 11th hour, which I’ve seen happen many times. So the idea is that you’re more likely to close, you can close faster. But the net proceeds to the seller are always going to be the same. And this is actually a situation that works better for distressed sellers and distressed property. So properties that need repair that are slower to sell, are hard to sell, or sellers who are very motivated, desperate, or in financial straits or situations where they just need to get out and get out fast.
What I sometimes refer to as a don’t want her. So that’s where you can get a better price by being that quote-unquote all cash buyer. So now that we’ve defined the all-cash situation, we’ve defined what it is. Let’s take a look at why you would not want to purchase all cash, which essentially are the pros of purchasing with financing. Before we do that, I think we should take a look at a simple example of purchasing $100,000 property with 20% down financing, 80% or purchasing it all cash. So let’s just assume a hypothetical example here of a property worth $100,000 and let’s say you purchased it all cash with $100,000 there is no mortgage on this. And for the sake of this example, just because the math will work out better, let’s just say this property rents for $1,200 a month, which is a very healthy rental amount for $100,000 property.
So if we assume taxes and insurance are $200 a month and all the other expenses average out over time, of course to $400 a month, we’re talking repairs, vacancy maintenance, cap-ex, whatever else may be factored in there. You’re looking at total expenses on this property of $600 per month. So that means your cash flow is $600 per month because it rents for $1,200 per month, $600 a month in positive cash flow net is $7,200 per year. This is actually pretty decent, and if you do the math, a hundred thousand dollars property, 7,200 per year, that’s a 7.2% cash on cash return, your cap rate is 7.2% your cash on cash return will be exactly the same, 7.2% so that’s not bad. Now, what if you finance that property with 20% down? Very common loan today, conventional financing, 20% down, that means that you have a mortgage loan for the other $80,000 from whoever that may be.
Whatever lending institution and interest rates today are ranging from four and a half, four, three quarter on the very, very low end to five to five and a quarter, five and a half on the high end. There are many variables involved here, but depending on your credit and whatnot, you can get a 30 year fixed rate mortgage for about 5% plus or minus. But let’s just say that the mortgage payments $400 per month. So for round numbers, we’re going to say that your total carry cost on this is a thousand a month, 600 in expenses which we’ve already covered, and then the 400 for the mortgage payment. So that leaves about $200 per month in net positive cash flow or $2,400 per year at least in the first year. And that’s what we’re talking about when you purchase it. Let’s compare that $2,400 per year with a finance property with 20% down or $20,000 versus the all-cash purchase with $7,200 per year.
When you do the math, 2,400 per year is not divided into the a hundred thousand dollars the $2,400 per year positive cashflow is divided into the $20,000 down payment. So if you do the math, you’ll see that’s a 12% cash on cash return. That 12% is much better than the 7.2% cash on cash with an all-cash purchase. That’s a pretty big difference and a significant one because this was just a snapshot of what year one looked like, but when you start to look at each and every year thereafter and what your returns are like because your cash flows accumulate and you got to aggregate those and then you have other returns, which I’ll talk about here in a moment. You’ll start to see that the compounding effect of your returns with percent down or in this case $20,000 really starts to grow. What looks like at an exponential rate, I’d like to say just compounds on itself each and every year, but it starts to grow not in a linear fashion but almost in an exponential fashion.
Don’t look at it as just one year, a snapshot in time. Look at it as a two, three, five, seven, 10-year investment and then some because that chart starts to curve upwards and there are more advanced strategies that we can talk about another day down the road on how you can take advantage of that, those returns on that equity growth. But the point here is is that you magnify your returns. When you don’t purchase all cash, you put a down payment of 20 or 25% this can add up to be a very significant difference. But there are four basic wealth generators here that we need to talk about. So it’s not just about the cash flow that is impacted by purchasing with a down payment and leveraging or financing the balance. It makes a big difference when you do not purchase all cash. And I’m not saying it’s right or wrong or you should or shouldn’t.
I’m just saying that you’ve got to compare the options here and look at the pros and cons. So these four items could be looked at as opportunity costs from the perspective of purchasing all cash versus financing. So the first one is appreciation. Let’s just say hypothetically again for the sake of math that this a hundred thousand dollars property appreciates in the first year, a full 10% which I know is very high, but this does happen and it goes to $110,000 so the value is 110,000 you put 20,000 down. So that increase in property value, this is an unrealized gain of course, but it’s a gain nonetheless is $10,000 in equity. So that 10,000 when you divide that into your initial down payment of $20,000 is now an increase a 50% so your net worth or your wealth if you will, has just increased by 50% on this property.
So that is a very significant gain. And of course, that could be different from year to year and it will fluctuate and sometimes it goes negative, but over time you average it out. You know, you can expect to see three to five, maybe 6% per year in many markets. Some markets are certainly stronger than that and we, you know, obviously like to target some of those markets for people who want that type of gain in appreciation. But that’s one of the benefits, if you will, of applying leverage to your investment. The second obviously is something we just talked about and that’s the cash flow and we already can see how that starts to become impacted with financing. It lowers the cashflow but increases your rate of return, your return on that investment, your cash on cash return. But when you can take that same investment capital purchase more than one property, multiple properties, then you actually increase your overall cash flow.
So the net result is higher, it’s not double, but is certainly higher, but you’re getting more cashflow across more properties, plus you’re getting the increased rate of return, the cash on cash return. Thirdly is the tax savings. So what happens here in this hundred thousand dollar house with an all-cash offer, if you’re clearing $7,200 per year in net positive cash flow and you have a tax deduction, really it’s what we call the depreciation on the property, which you can do over 27 and a half years. That’s approximately $3,000 per year. Just simple math here, if you apply that $3,000 deduction against the 7,200 you’re still left with a positive profit on the property, which can be taxable depending on your tax situation. This is a conversation you need to have with your CPA. But if you use leverage, your cash flow is now $2,400 per year after all expenses as we talked about before.
So at this point, you can take that $3,000 tax deduction, the depreciation against the $2,400 and you will show a loss on paper, but you still have a positive $2,400 per year of cash flow. So you’re still cashflow positive. You actually have real spendable dollars that can go into your bank account or in your pocket, wherever it may go. But on paper, you’re showing the deduction from the depreciation. So you’re actually showing a paper loss, which you can actually apply to other passive income sources if you have them. Again, have a conversation with your CPA. This is a very simplistic discussion, an example, but I’m just trying to illustrate the possibilities of what can be done and what you stand to gain. And lastly, is the loan pay down or the amortization of the loan. So when you have a tenant and they’re covering all your expenses and your debt service, your tenant is essentially paying off that $80,000 mortgage a little at a time, uh, and increases year over year, but they’re essentially increasing the equity in the property month after month and year after year, which adds to your overall wealth or your net worth.
You can also look at that as a return on your investment because I’ve actually did the math, I created a spreadsheet to show what your quote-unquote return is from the equity gains from the amortization of the loan relative to your down payment. If you actually look at a 30 year fixed rate mortgage on a property and you look at how much principal’s being paid down year after year, if you take the average over 30 years, your rate of return on that mortgage is 13.3% per year. Now, it’s not 13.3% in the first year. It’s more like five-point something 5.6% and it’s around the 17th year where you’re actually seeing 13.3% but over the course of that lifespan, the amortization of that loan, you’re essentially getting on average 13.3% return on your money, the $20,000 down payment from the principal down payment. The press gives me that principle reduction in that mortgage, and if you’re not following me on this, don’t worry about it.
I’ll talk about this in another episode, but the point is, is this your tenant living in the properties paying rent, that rent is helping to pay down your mortgage. The principle reduction in that mortgage is an increase again in the equity in the property. So if you take that, gain that return in equity in the property and again divide that yearly gain into the $20,000 down payment, what you will see is a rate of return. It’s smaller in the beginning. Year one is five-point something percent and then it just slowly increases. But if you take an average over those 30 years, it’s 13.3% that is your rate of return in terms of the equity gain from the amortization of loan. A beautiful, beautiful thing. So even if the property didn’t appreciate just through market appreciation or price inflation appreciation, just the amortization of the loan by itself has given you a rate of return greater than 5% but averages out to 13.3% so you lose that essentially by not financing your property.
So these are the opportunity costs. It’s the equity gains, the tax savings, and the cashflow that are there for you that you can leverage or magnify, multiply by using a down payment and purchasing more than one property. In other words, not buying all cash and you can do that across more property. Now, let’s consider some of the cons if you will. Buying all cash can be a liability. Now, how is that? It’s not that you have debt because this is good debt. It’s debt that allows you to rapidly increase your wealth creation, but it’s not bad debt because you’re leveraging this into cashflow and assets that produce income. But the reason the all-cash purchase can be a liability. It’s really from a legal perspective, this is a, you know, an unlikely situation, but let’s just say, what if you had a lawsuit and what if this was one of your tenants suing you over something, uh, at the property?
Now, how often does this happen? Very rarely, and not saying it doesn’t happen or hasn’t happened. It’s in the last 16 years, I don’t think I’ve ever met or talked to anybody that’s had a lawsuit from a tenant, but from an asset protection perspective, you have to understand that when an attorney looks at properties which you don’t hold in your own name, of course, you always want to have your asset protection plan in place, which means that you have entities like LLCs, for example, holding title to your properties. When you have your properties sitting there with equity, lots of equity and attorney can look at that and say, Oh, well this property has a lot of equity that we can go after and attach a judgment to through the LLC or whatever it may be. Also in some cases rare cases, but in some states, depending on the situation, you could be forced to sell a property in order to make good on a judgment on a suit.
But again, these are extreme examples. The point is is that if you have a property with an $80,000 loan and the $20,000 equity position from your down payment, that’s going to be a difficult thing to go after. An attorney’s not really going to want to bother because by the time they force a sale, probably have to discount it and then you pay realtors fees and closing costs. It doesn’t really leave a whole heck of a lot to satisfy the judgment and then pay the attorney who is doing this on a contingency basis in order to get paid. So when you have debt on a property, think of it like insurance. In a way, you’re actually protecting yourself because there’s nothing to go after. There’s not a lot of equity in the asset. And so that’s one of the benefits of actually having financing on a property.
Not that you necessarily want financing or debt on a property forever, although that is one type of strategy, but it just differs or what I meant to say, detours, potential lawsuits. The second con is that it makes the property fairly illiquid. So if you have financing on a property, it’s going to be difficult, more difficult to sell that property or refinance a property to pull that equity back out. So if you need access to your funds and you have a property that’s sitting there all cash, it might be a little easier to sell. Certainly, it’s going to be easier to refinance and pull out cash if you need it. And then of course, if you’re purchasing a property now all cash with the idea of refinancing it down the road, let’s say a year from now, the fact that you actually had to close and pay some closing costs now and then refinance at a year from now with some additional closing costs for the lender and the title company and for the loan officer and the processing of the loan, all that stuff, you’re incurring additional closing costs to refinance solely for the purpose of pulling cash back out to reinvest elsewhere.
So it’s a little bit more expensive doing it this way and I don’t recommend you actually do it that way. Uh, so it’s if you’re going to finance it a year from now, you’re better off financing it now instead of doing a two-part transaction, just have a one-part transaction. Last, but not least for the reasons we described before. You know the cash flow, the appreciation, the tax savings and the loan pay down, you’re really affecting your ability to build wealth drastically because of the fact that you can buy more property sooner, faster. Using leverage and controlling more real estate allows you to exponentially grow your wealth and that it means more cashflow. It means more equity growth and that’s really the biggest con, if you will, for not financing. In other words, buying all cash. To sum this all up, if your goal, like you said before, is to purchase 10 properties in 10 years and you’ve got $200,000 to invest.
Let’s look at it this way, with $200,000 assuming that a down payment is roughly 20,000 then you’ve got miscellaneous closing costs and you’re going to hold some cash in reserve. Let’s just say $25,000 is what you need to purchase. One single-family detached home in a B, B plus area. Typically a three-bedroom home, maybe a one and a half bath, two bath home with $200,000 you can purchase. You can invest in eight properties right now today, so your goal of 10 properties in 10 years can be 80% accomplished right now over the next three, four, maybe six months, however, fast you want to go, you don’t have to wait 10 years. You can get eight of those 10 properties done in one year, maybe even six months. So you have the capital, you have the resources to do that. If you’ve got qualifying credit, talk to one of our investment counselors and map that strategy out.
That is very, very doable. It’s done all the time and you don’t have to wait or drag it out for 10 years and that’s also a benefit because you don’t have to wait to add a property per year and miss out on the cash flows and the potential appreciation that and of course the amortization that you would get holding those properties as your own over the next eight years that you would have planned to have accumulated those eight properties over. Just do it in one year. Now you have them all at the end of one year and you’re off to the races. So again, this is going to be different for everybody. If I had to pick a strategy, I’d say finance the mall and do them as soon as possible. There’s no reason to wait. There’s nothing pressing you to drag it out. I just see more benefit in just having it available here and now than it does dragging it out over eight or 10 years.
So I would say finance them, and this is not specifically for you, but just based on the situation you have, I would just finance a portfolio of eight to 10 properties as soon as you can, as quickly as you can and just geographically diversify them across two maybe three markets and you’re going to have all the benefits that we talked about. So again, talk to your CPA and talk to your investment counselor and whoever else you need to discuss this with. But I think going forward it would be a solid plan to just finance. I don’t think you’re going to get a better deal buying all cash because again, you’re going to have to be talking to motivated sellers, people who are in a distress situation or have distressed properties and are more quote-unquote desperate to sell and we’re not in a buyer’s market.
So trying to chase after that sweet deal is going to be very difficult. And if it is out there, guess what? There’s a lot of other people chasing after that. You know that screaming deal that can be purchased with an all-cash purchase. So that’s it, Conrado. I hope that helps.
I hope you enjoyed this week’s throwback Thursday episode. If you haven’t already, remember to subscribe so you don’t miss out on a single episode. We’re releasing one every week, sometimes two, and I would not like it if you missed an episode. There’s just a lot of great nuggets and good content sprinkled throughout this show. If you have a question about real estate investing or finance, simply go to passiverealestateinvesting.com and click the Ask Marco button. I read all of them, I reply to many of them, and sometimes I cover them on the show, and I’m gonna try and do more of that. So, I am going to encourage you to go to passiverealestateinvesting.com and submit your question for Ask Marco. Lastly, help us share the show with other like-minded people that you know who can benefit from it as well. Just visit us on your platform. Most of you are on iTunes and leave us a rating and review. I would greatly appreciate it. I read them all and I will thank you in advance. And that is it for today. Thanks for listening. I will see you on our next episode.
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