Most of the time, real estate investors secure financing when purchasing rental properties. Many obtain a conventional mortgage from a lender, others get hard money loans or use asset-based lenders, and still others borrow against other properties. These investment vehicles have provided an attractive alternative investment class to stocks and bonds over the years.
In this article, we examine what to consider when deciding between paying for a rental property with cash or financing it. Keep reading to learn the benefits and drawbacks of paying with cash, what cash on cash return to aim for, how much cash flow a rental property should bring in, and more.
Is it Better to Pay Cash for a Rental Property?
There are several reasons buying a rental property with a mortgage can be a smart idea. For one, mortgage interest is a tax-deductible expense. It’s also easier to save for a down payment than buying an entire rental property outright with cash.
Furthermore, if the mortgage rate would be lower than the current average rate of return on the stock market, it can sometimes make sense to invest the cash you would have spent on a property.
However, for every point towards getting a mortgage, there is a counterpoint in favor of paying cash.
While mortgage interest is tax deductible, it can severely affect your cash flow. Although it’s easier to save for just a down payment, qualifying for a loan comes with its own challenges. You need to build a good credit score, reserves for mortgage payments and meet additional requirements.
Plus, paying cash for a rental property comes with extra benefits. Namely:
- Cash payments tend to lead to much quicker purchases and closing can often take place directly after an inspection.
- Further, cash offers typically carry more weight with sellers, thus making you more competitive.
- Finally, your closing costs are lower as well.
In my personal experience, my wife and I recently closed on our own home using a conventional mortgage. While not a rental property, it does still hold true for the broader residential real estate market.
In our area, many potential buyers have enough financial wherewithal to make all-cash bids and have no need for financing. In instances like this, sellers almost always prefer to go with an all-cash offer as they do not rely on receiving a bank’s approval and they also close in half the time as a financed purchase.
Obviously, your mileage may vary in either circumstance, but as a rule of thumb, sellers prefer all-cash offers for their simplicity, lower risk and faster closing potential. As a buyer, they also represent lower closing costs as several of the items a bank would need to purchase and run on your behalf simply do not need to get done for an all-cash purchase.
Usually, closing fees account for 2-5% of the total purchase cost of a building. When you use cash, you can skip paying for mortgage insurance, lender fees, title insurance, origination fees, and more. Further, you won’t lose as much money if there are vacancies because you don’t have a monthly note to cover.
With mortgages, the investor is also exposed to the risk of foreclosure in the event monthly mortgage payments aren’t made. Conversely, when you buy with cash, you have full ownership and equity. Perhaps most appealing, you have the peace of mind that your purchase hasn’t put you in debt.
What is a Good Cash on Cash Return for a Rental Property?
Cash on cash return is the calculation of yearly before-tax cash flow as a percentage of the total amount of money invested. It’s expressed as a percentage.
While some investors use the terms cash on cash return and return on investment interchangeably, they are actually different.
Your cash on cash return is compared to the cash spent out of pocket, while your return on investment measures the returns on your entire investment, including any loans you took out.
Some people also confuse cash on cash return with cash flows from assets. However, cash on cash return is expressed as a percentage and cash flow is expressed as an amount.
Furthermore, cash on cash return shows the return you’re receiving for the total amount invested. In contrast, cash flow demonstrates the amount of money you’ll have available to deposit into the bank after your expenses have been paid (excluding income tax).
Before calculating your cash on cash return, you need to determine your annual cash flow. This is your monthly cash flow (income minus expenses) multiplied by 12. You can risk-adjust this to account for potential vacancies you expect to experience throughout the year.
For example, if you plan to have the property occupied 10 months out of the year on average, you can multiply the monthly cash flow by 10 and then divide it by 12 to give you a monthly cash flow figure which accounts for potential vacancies.
Once you look at the monthly cash flow projection with an estimate of vacancies, then you use the following formula:
(Annual Pretax Cash Flow / Initial Cash Outlay) x 100% = Cash on Cash Return
Tax is excluded from the cash on cash calculation because the amount of income tax paid isn’t the same for every investor. Excluding tax makes it simpler to compare investment opportunities.
Consider your investment objectives when looking at your cash on cash return. When investing in a growing market, or one that has assets that appreciate in value quickly, you might have a lower cash return. That doesn’t necessarily mean it’s a poor investment nor a bad way to make money while you sleep.
Note that cash on cash returns will usually compress, meaning they decline as a cycle lengthens. Returns are higher during the earlier part of an economic recovery and decline in the latter stages. This is because prices following a recession are typically lower and the perceived risk is higher. As the economy does better, more money enters the market, prices rise, and cash on cash returns decline.
Many investors agree that between 8 to 12 percent is a good cash on cash return. Others believe that in some markets as low as 5 to 7 percent is good. Again, it depends on your objectives, local market and other factors.
That said, you don’t need to invest only in your own market. Look below for some opportunities to invest in real estate outside your local market at the bottom of this article.
How Much Cash Flow is Good for a Rental Property?
In the real estate realm, cash flow is the difference between your property’s income and expenses, including debts. A positive cash flow means your income is greater than expenses and financing costs. A negative cash flow means your expenses and financing costs are greater than your income. In other words, you’re losing money.
The higher the cash flow, the more money you earn. This not only helps you build generational wealth, but can work as a cushion if you go through a period with too many vacancies or need cash reserves for other reasons.
To calculate a rental property’s cash flow, take the following steps:
- Determine the property’s gross income.
- Subtract all of the property’s expenses.
- Subtract all of the property’s debt service.
The difference is your property’s cash flow. A common way to increase cash flow is by making improvements, such as doing renovations or adding amenities through the BRRRR Method. There isn’t a set number for what rental cash flow is enough because investors have different goals.
The type of rental property plays a role because investment properties with multiple units usually have higher cash flows than single-unit properties. Additionally, more expensive properties, which are generally higher risk, warrant higher minimum cash flows than less costly investments.
To determine if a rental property will have enough cash flow, many investors look to the 1% Rule or the 2% Rule, discussed below.
What is the 1% Rule in Real Estate?
In real estate investing, the 1% Rule states your monthly rent should equal a minimum of 1% of the rental property’s purchase price. This rule ensures the monthly rent will exceed the property’s monthly mortgage payment (if bought with a mortgage). You want your rental income to be more than (or at least equal to) your mortgage payment so you aren’t losing money each month. If you paid for your rental property in cash, this is less of a concern.
With the 1% Rule, if a property rents for $2,000 per month, you know not to pay more than $200,000 on that investment property. This quick estimation doesn’t account for other costs, such as MACRS depreciation, taxes, landlord insurance, and maintenance.
If you have already bought the property, take the property’s price plus necessary repairs and find 1% of that to determine the lowest amount you could charge for rent, keeping in mind that higher would be better.
What is the 2% Rule in Real Estate?
The 2% rule uses the same idea as the 1% rule, but this rule says a rental property is only a good investment if the passive income every month is equal to or higher than 2% of the original purchase price. It’s calculated the same way as the 1% rule, but with 2%.
With this rule, if a property rented for $2,000 per month, you wouldn’t want to pay more than $100,000 to purchase it.
The reason some investors use the 1% rule, while others use the 2% rule, is that other factors are at play. For example, if your main goal is positive cash flow, the 2% rule is useful.
However, if your main focus is obtaining a property you expect to appreciate significantly in value, you wouldn’t necessarily need to use the 2% rule.
Both the 1% Rule and the 2% Rule are only useful at the beginning phase of evaluating real estate investments. They are a quick screening tool to determine if you should look further into a property. Consider these less of “rules” and more of “guidelines” as some experts disregard these rules completely.
While the 2% rule usually works best in the Midwest and southern parts of the United States, it can be much more challenging to find investment properties that will pass the test in cities such as Los Angeles or Boston. In some cities, these results simply aren’t realistic. If you have interest finding properties renting at this rate outside of your area, see the crowdsourced real estate investing options highlighted below.
Remember to keep both your goals and location in mind when deciding if you should implement the 1% Rule or the 2% Rule.
Can You Invest in Rental Properties Without Physically Possessing Them?
Many people want to take advantage of the benefits you gain from paying cash for a rental property, but simply don’t have sufficient funds to purchase outright the type of rental property they want. Fortunately, for these people there is another option. It’s possible to obtain partial ownership or financing of rental properties through crowdfunded real estate.
This type of real estate investing allows you to earn returns based on the performance of the underlying assets in your portfolio.
Not only does this real estate investing strategy help you invest in real estate for less, but it also removes the responsibilities and stress that come with purchasing a property, maintaining it, and selling it later. If you reinvest your dividends, you have the potential to earn more. Note this is a long-term investment and highly illiquid.
Read more below on some popular options for investing in crowdsourced real estate.
Investing in REITs
A popular alternative to crowdsourced real estate investing is to invest in real estate investment trusts (REITs). This is a more liquid option which allows investors to purchase shares of a REIT through a service like stREITwise or through other free investing apps.
REITs are bought and sold similar to stocks and can be bought on most major exchanges. You receive dividends and can sell your shares at any time.
I recommend using stREITwise to invest directly in a REIT or the Webull app, which offers several useful tools for analyzing numerous REIT investment opportunities. The latter acts as one of the best stock research apps.
Is Paying Cash for a Rental Property a Good Idea?
While there are tax advantages to getting a mortgage when purchasing a rental property, such as the tax deductions, there are many more reasons to pay with cash. Not only can it minimize your debt, but it can save you money in closing costs, insurance, and more.
When deciding if a rental property is worth your money, consider the expected cash on cash return as well as the estimated cash flow. The 1% Rule and 2% Rule can work well as initial filters.
If you aren’t financially or mentally ready to buy an entire rental property, consider crowdfunded real estate platforms, such as EquityMultiple, Fundrise, or Groundfloor, or buying shares of REITs through a services like stREITwise or Webull.
Remember that no two rental property situations are exactly alike. Consider your goals, location, and other financial plans before purchasing a rental property.
About the Site Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see the disclaimer on my About Young and the Invested page.