Editor: In the Hybrid model of financial Independence, we must come up with sources of cash flow for retirement. This can involve taking a safe withdrawal rate from the nest egg you’ve saved. It should also involve streams of passive income. One of the potential streams of income you can utilize may involve real estate – and specifically – rental properties.
That’s what this Saturday Selection, which was originally written by and published on Passive Income MD, is all about.
Why You Should Pay For Rental Properties In Cash
In the real estate investing world, there is no shortage of debates. One of my favorites is this (seemingly) simple question:
Should you pay for a rental property in cash or use leverage (financing)?
There is some debate on whether there even is a right answer, and of course, it all depends on who you ask. The reality? There are so many factors going into making this decision that it can be a very difficult question to answer.
So, should the time come for you to act on this decision, I’ve decided to create a two-part series that takes a dive into both sides of this argument.
For this first post, let’s talk about the reasons why cash is king when purchasing real estate.
Purchasing real estate isn’t like going shopping on Amazon. There, you see an item, push the “buy” button, and you’re guaranteed you’ll be able to purchase it. Real estate is almost never like that.
People normally talk about two parties in every transaction: the buyer and the seller. But it can be easy to forget that there is competition to become the sole buyer in that transaction. In fact, the better the deal is, the more chance there is that you’ll be competing against others.
In order to make their decision, sellers often use certain criteria to pick a buyer. Obviously, the purchase price is the major factor. But other important factors may include certainty and speed (see my next point) of the transaction. Essentially, if a seller goes into a contract with a buyer, the seller wants to know that the buyer won’t back out of that contract.
One of the major things that screws up transactions is the inability of the buyer to get financing in place. It’s simple, if they’re not able to get a loan, they’re not buying the property.
So when the buyer has cash ready to go, the wild card of financing is no longer an issue. It provides the seller with more certainty that they’ll be able to complete the transaction to the satisfaction of both parties.
While it may not be strictly necessary, bringing an all-cash offer to the deal gives you a significant leg up on any competitors who are using financing.
2) Speed of the Transaction
When you’re looking to purchase a property, there are all sorts of things that need to take place before the deal is completed. These can include inspections, title reports, and more.
But what always seems to take the longest is making sure the financing is in place. The bank needs to do due diligence on the buyer as well as the property, and that takes time.
In those deals where time is a factor (and it usually is), paying in cash eliminates the bank altogether, which significantly reduces closing time.
In relation to my previous point, this creates more certainty that the deal will actually get done. After all, no-one likes to sit in limbo.
Sometimes, people are simply on the clock to get things done. For example, they may need to get into another building for a 1031 exchange within a certain time period. Or, maybe they’re trying to purchase another property and they need the cash from the sale to move into the next one.
Or perhaps, as in the case of my own next property purchase, the seller needs to make the sale happen before the end of the year– otherwise, the tax for sale of the property in that state increases significantly.
Whatever the reason, buying in cash allows for a smoother and much speedier process.
3) Lower Closing Costs
Closing fees usually account for 2-5% of the total purchase cost of the building. Closing costs are paid when the property is acquired, and they could include:
- Title fees
- Mortgage lender origination
- Mortgage insurance
- Title insurance
If you pay cash and avoid financing altogether, you eliminate the last three on that list. Getting rid of those fees can mean a 1-3% difference in the cost of the transaction for you. If you’re buying a one million dollar property, then you could be looking at a savings of $10,000-$30,000 versus financing.
When you look at it like that, cash becomes a pretty tempting option.
4) Lower Monthly Expenses
Monthly expenses like property management and repairs are inevitable. But there’s also something known as PITI (Principal, Interest, Taxes, Insurance), which is also usually a given. At least, that is when you’re financing.
If you don’t have a loan, then there are no principal and interest payments, and these two usually make up the largest monthly expense. What does that result in?
That’s right, a higher positive cash flow, which leads right into my next point.
5) Simpler, Immediate Cash Flow
If you subtract expenses from income, that equals net cash flow. If you can lower your expenses by not having a mortgage, then your cash flow could be significant right off the bat.
If immediate cash flow is something you’re looking for, then paying all in cash makes it easy.
It is possible to use leverage/financing to receive a higher cash-on-cash return (meaning a higher cash flow return on the amount of money you put in), but that can take time and usually more effort. As with anything, it really just depends on your goals.
Paying in cash gives you that instant cash flow, which can be quite helpful.
There are, of course, multiple risks when it comes to owning real estate.
One of the largest is the risk of foreclosure and losing the property. Financing and having a mortgage means you have a monthly debt obligation to the bank.
What if you have vacancies and you can’t make up the difference to pay the monthly mortgage? Well, the bank can foreclose on the property and take it away. In that scenario, you will have lost 100% of your investment.
But, to put it simply, if there’s no bank then there can be no foreclosure.
Well, technically the county can foreclose if you don’t pay your property taxes, but again, that’s typically tiny compared to the mortgage payment. If you have vacancies and you’ve paid all cash without a mortgage, that pressure to perform is significantly minimized.
Paying with cash means much less chance that you’ll lose the building and your investment capital. Leverage can be a powerful thing, but it’s a double-edged sword. It can magnify your gains, but it can magnify your losses as well.
7) Easier Estate Protection Process
For smaller properties with residential loans, the bank can make it quite difficult to place the property in an LLC for asset protection purposes.
Banks typically do not like this scenario and have the right to call the loan (meaning asking you to pay for the loan in full) if you try to move the property into an LLC.
You might find yourself having to leave the property under your own name, leaving you personally liable for any issues. Either that or you can put it into the LLC and risk having the bank call the loan.
Or, I’ve heard of situations where you can use something called Land Trusts to provide protection as well and we’ll explore that in a future post.
In any case, things always get more complicated if banks are involved. Paying in cash means you’re free to do what you want with the property, without risk of having to pay the loan back in full.
Just make sure you always talk to an expert when it comes to asset protection issues to make sure it’s set up correctly.
At the end of this post, you may be thinking that cash is definitely the way to go. While you may not be wrong, there are always two sides to every debate. Ultimately, paying in cash may not be the flashiest way to purchase property, and may be slower and more methodical. But, it can certainly allow for better peace of mind and a speedier transaction.
Stay tuned for the next post in this series, where we’ll explore the other side of the debate: why using leverage is a powerful and great way to acquire real estate.
What do you think about purchasing a property all in cash?
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