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My First Rental Property--Buy Cash or Get Mortgage?

"I am thinking of buying a rental property. If I have the cash, is it better to buy a property with as much cash down? Or is it wiser to take out a mortgage? With a mortgage, the overall cost to purchase the property is more than with a cash only option. What do you think?"

Congratulations on saving up enough cash to be able to buy a home outright.  This means that you have many options of what to do with this money including purchasing a rental property.  I have several rental properties myself and frequently advise clients on rental properties that they are considering from a numbers perspective (I do not actually go to the homes and offer my opinion that way).  The first thing that I tell anyone that is considering investing in a rental property for the first time is that you are now starting a business.  Like any business owner, you need to understand all the numbers associated with your business and be willing to put in the time to make your business successful.  This is by no means a hands-off investment.  If you want it to be a hands off investment—do not do it!

In some circumstances it may make sense to purchase a rental property all in cash.  This could be that you are in retirement, are in a low tax bracket, AND need the additional cash flow associated with buying the house in cash.  If this is not the case for you, then I strongly discourage you from buying a rental property with cash unless it is a strategic cash purchase to win the contract and you ultimately plan to refinance it once the purchase is made.

In my opinion, it makes the most sense for you to put as little down as you can and still cash flow on the property.  If you can get by with 0% and still make money, why wouldn’t you do that?  That is the ultimate return on investment (ROI).  In order to make that happen, you need to find an incredible deal on a property AND have access to non-traditional lenders who see the value that you are getting on your purchase.  Needless to say, this is very rare, but I use it to emphasize my point that if you can find the deal that allows you to put $0, then your ROI is infinity.  This probably isn’t going to be the case for you in trying to find your first rental property, but I use it to illustrate my point that you still want to put as little down as you can because that enables you to leverage the return on your investment.  Since you are probably going to go the route of a traditional lender, then I would suggest putting down just enough to avoid PMI.  This is usually 20-25% depending on the lender.  I also strongly recommend a 30 year mortgage.  Too many first time real estate investors choose 15 year mortgages because of the lower interest rate.

With this sort of down payment and term, you should still be able to cash flow.  By that I mean that after you pay for your mortgage, taxes, interest, maintenance, insurance, account for vacancy, and other expenses, you still have money left over each month from rent.  I would suggest a minimum cash flow of $200/month though I usually will not invest unless I can make $400-$500 per month.  Keep in mind these are difficult to come by.  If you are not able to cash flow, with this level of down payment, then this is probably not a very good rental property from a true rental property perspective.  The reason I mention all of this is for you to be able to make a better investment decision.  Notice that if you pay cash for a property, you do not have a mortgage payment.  Thus, you should very easily be able to cash flow.  The problem is, this doesn’t mean you bought a good rental property.  Most any property will cash flow if you buy it all in cash.  That doesn’t mean every property is a good rental property.

There are several more reasons not to buy in all cash such as leverage, potential diversification with other investments or properties, and liquidity.  I will not go into each of these because I have gone on far too long already.  I hope this has challenged you and helped you at the same time.  If you can’t tell investing in real estate is very different than buying your personal residence.  As always, consulting with a fee only financial planner who does real estate analysis should be very helpful and well worth the cost to offer a third party opinion on the significant investment you are considering.  Good luck!