Often I am asked, “Is it better to buy properties using all cash or to finance with a loan?” The answer is, “Both.” The old saying, “Cash is King” is true… IF you never run out of cash… but, since all of us, even the wealthiest people in the world, are on some kind of finite budget, having the ability to secure vast amounts of loan financing is often more valuable than having only an exhaustible amount of cash. Knowing when to use your own cash or when to use someone else’s cash is the question you need to answer. This blog is dedicated to maximizing your return from your income properties by recognizing the pluses and minuses to using cash versus loan financing.
When you purchase with cash, you will receive five distinct perceived advantages, but are they really advantages or just popular myths? First, you will qualify for any type of sale that you are entertaining, i.e. REO properties, HUD properties, VA repos, Short-Sales, Conventional Sales, Courtroom Steps Auctions etc… A seller may reject your offers on the grounds of price and terms, but, it’s a guarantee, no seller in their right mind is going to tell you, “hmmm…I don’t know if cash is going to work for me”… unless you’re our own government (there are certain government attached properties that give preference to certain types of financing). When financing a property purchase while using a loan, your options can be restricted based on the type of sale, seller requirements, and property condition (many lenders will not lend funds if property condition is not at a certain expectation which is noted in the property appraisal).
Secondly, cash financing has an advantage in that it can allow for a quick closing. That means, usually, less chance of a long; strung out, escrow process, hence less stress. It also means you, as the savvy buyer, can quickly start making income from the property by renting or reselling it. Furthermore, as a seller, your eyes light up because cash financing looks like a ‘sure thing’ and it’s perceived that a seller will be able to accomplish their goal of selling their property… at least in theory. Therefore, a cash buyer usually receives preference from a seller, as long as the terms and purchase price are similar, over all other forms of financing (again some government sales this generalization is not true).
The third major advantage cash has over financing is there is no risk of failing to finance. Therefore, not only is the seller going to feel more at ease, but you, as the buyer, can too, which will free up time and energy to move onto other investments or concentrate on other aspects of your life. Time is money. Too often buyers fail to finance for many reasons, a property appraisal comes in low, a property condition comes in unsatisfactory to the lender, or the buyer owns too many other liabilities such as other properties or vehicles that have loans on them also and the lender now feels uncomfortable issuing another because of the ‘debt to income ratio’ risk looks unsafe to the investors backing the new loan.
Fourth, it’s cheaper to use cash…really? On one hand, yes, using cash can save you money on your closing costs, usually about 1% of the property purchase price and it can save you and the seller time. However, on the other hand, your cash is now tied up in that property, upon purchasing, for usually a minimum of six months if you plan to refinance or about 30-90 days for if you choose to sell. If you ever want the cash out of the property, you will need to commonly, sell, take out a home equity line of credit, or do what is called a cash-out- refinance, two of the three will cost you many more percentage points than the 1% extra you pay to use a loan during your original purchase. So, perhaps, because of its rigidness, cash is not the cheapest way to go, figure out your own homework and keep track of your own bank account to know for certain.
Fifth, as a cash buyer, many people argue that you receive the ‘peace of mind’ of not having a monthly mortgage payment to cover. This can be true. Much like the time aspect pointed out in number two, having peace of mind and decreasing your stress level will allow you to think more clearly and focus on other things. However, if you take a moment to contemplate life, you’ll see, often, you’re only kidding yourself. Each year inflation, taxes, college tuition, retirement, entertainment, food, gas, and other ever climbing life costs grab a piece of your pie faster than your salary is probably increasing (in the last 10 years the average United States worker has actually had a 10% decrease in their salary/wages and an increase in their taxes). You’re currently fighting a losing battle and need to find new ways to bring your income and quality of life back up to where you desire it to be. When you purchase real estate using cash financing your return on your investment differs dramatically from the return on the investment you would receive when purchasing using loan financing. A cash buyer may be receiving a 12% gross return on your investment if he/she purchases a property for 97K (estimated 3K closing costs equals 100K total) and the property rents for 1000K per month. On the other hand, a loan buyer that has the same 100K in his or her bank account, purchasing the same 97K property (estimated 3-4K closing costs) places about a 20% down payment (20K) to receive their loan of about $600 per month on a 30 year fixed mortgage (figure roughly includes taxes and insurance in Las Vegas). This would allow them to purchase five properties instead of only one for the same 100K. As long as they receive a loan with a good percentage rate (today’s general investor rates are about 5%) they will come out far ahead in the game. In this scenario, with five cash producing properties instead of just one, the actual dollar figure they would come out ahead would be rough $1600.00 (4 X $400) per month (That’s almost 20K per year), and that figure does not include possible tax write offs or property appreciation! There you can easily see, if you’re limited on cash, cash becomes queen and leverage is king by using your good credit to obtain more financing from loans.
So, for all those pessimists and worry warts out there who are about to pipe in and say, “What happens when my properties are vacant or rental incomes drop and I now have to cover a mortgage?” Remember, first, a savvy investor always ensures they purchase cash flow positive properties or have hard and fast rules for selling a losing investment when they do buy. Second, with the rising costs of your daily world, doing nothing about it is really not an option and most people’s quality of life is currently continuing to deteriorate without solid investments. Third, you’re making $2000.00 per month positive cash flow when you are renting all five properties (5 X $400). In a scenario where two of the five properties sit vacant for long periods of time (minus $800 from your cash flow and add $1200 to your expenses by covering your vacant mortgages out of your own pocket), you will still be at a breakeven point which can actually usually still be pushed into the green with tax incentives claimed on your “depreciating,” “losing”, “investments” when tax time comes around.
For those of you who are still worried and want to play it ‘safe’, buying with cash will at least allow you to cover some of your everyday losses from economic inflation, however, remember, if your one and only property goes vacant, then you will have no income coming in at all. The bottom line, all investments have risks, mediating those risks is key and doing nothing is really not a viable option unless you want to accept a lesser quality of life in the future. If you don’t believe me and would like to verify, next time you drop by the grocery store, take a look at the prices of everything. As a practical exercise, pick out a handful of your favorite items you used to purchase as a kid and compare them to the prices you used to purchase them for. My example is Starkist Tuna fish; I used to buy these cans as part a staple diet all through college less than 15 years ago for 38 cents a can. I just saw them at Sam’s Club, a usually ‘cheap’ vendor, last week for just over $1.00 per can. When you conduct this experiment, if you notice one or more of your examples has not shot up in price, I challenge you to then check the quality. Usually you’ll notice the quality dramatically went down if the price did not shoot up. For those of you who still feel purchasing property is too much of a risk, perhaps real estate investing is not the right type for you, perhaps you would like to continue contributing to a 401K that ‘someone else’ overlooks, because we all know those ‘safe’ investments all preformed so well in the last few years.
Lastly, please notice how nowhere in the above paragraphs have I ever mentioned that cash will give you a ‘discount off the property.’ Sometimes people argue with me until they are blue in the face that, strictly because they are purchasing with cash, that entitles them to a huge discount on every property they deem interesting. It is true the a cash buyer has a greater chance of creating a ‘low-ball’ scenario, however, this absolute ‘must be’ opinion is one of the biggest myths in the real estate industry as a ‘discount’ off a property has to do a lot more with the motivation of the seller than any kind of financing that is ever used for the purchase. For example, at the courtroom steps auctions, banks liquidate their distressed property holdings for immediate cash. They are willing to sacrifice money, in offering a discount to quick cash buyers, in exchange for saving the time and energy it will take to place a property onto the retail market and then waiting for a buyer to come. On the other hand the buyer is willing to risk certain protection concessions and incur more liability. Again, time is money on both sides.
Don’t be fooled, often a buyer using financing has received a better ‘deal’ than the cash buyer; it’s all in the motivation of the seller. Remember also, terms of sale are more important than the purchase price itself. If you get fixated only on price, you will always fail to maximize your profits. As a true investor, you should be willing to buy absolutely anything as long as it provides the correct terms of sale. Ask yourself, if you knew of a prospective rental property would provide you a 100% return on your money for many years to come, would you feel comfortable buying that property for more than it is worth (appraised value) or do you feel the need to buy a property at a 20% discount no matter what even while it may currently rent for a 5% return on your money and looks to be dropping in value? I know your answer is, “I want both the discount and the return,” all investors say that, but the reality is, there are 24 hours in a day, seven days in a week, and 365 days in a year. If you’re always waiting for the ‘perfect deal’ to come along, you just missed several ‘good deals’ that would make you a lot more money than the one perfect one that may never even come. Furthermore, a sale type like an auction that provides very little safety measures for your money may end up being a money pit for you instead of a safer retail market investment that usually affords luxuries such as title insure and other contractual safety nets.
Thank you very much for reading my blog, I hope this information helped you out. For this blog and other helpful tips and tricks please visit our tourism and real estate website http://PlacesInLasVegas.com or, for all aspects of general real estate, our parent website http://LasVegasRealEstateConnection.com.
*All blogs are personally written by James. Although we encourage and are grateful for sharing, all information is copyrighted by James and needs to be given credit. Thank you.
This blog was originally written 11-18-2011