Paying cash for a rental removes the biggest bill the property has and the biggest risk it carries. It also ties up four times as much money in one house.
Run the same property both ways and the trade is easy to see, because the two numbers people care about move in opposite directions.
What changes when you pay cash?
Take a $250,000 house renting for $2,750 a month, with $3,000 a year in property taxes, $1,400 in insurance, 5 percent set aside for empty months, 5 percent of rent for repairs, 5 percent for big replacements and 8 percent for a manager. The only thing that differs between the two columns is the loan.
| Paid in cash | 20% down | |
|---|---|---|
| Rent | $2,750 | $2,750 |
| Empty months (5%) | −$137 | −$137 |
| Property taxes | −$250 | −$250 |
| Insurance | −$117 | −$117 |
| Repairs and big replacements (10% of rent) | −$275 | −$275 |
| Property management (8%) | −$220 | −$220 |
| Mortgage | – | −$1,331 |
| Left each month | $1,751 | $420 |
These are example figures, not a quote.
The cash buyer keeps $1,331 a month that the borrower hands to a lender. Over a year that is nearly $16,000, and it arrives whether the house is doing well or badly.
Why does the return fall when the cash flow rises?
Because the cash buyer put in $257,500 to get it, and the borrower put in $57,500.
| Paid in cash | 20% down | |
|---|---|---|
| Cash in at closing | $257,500 | $57,500 |
| Cash flow a month | $1,751 | $420 |
| Return on the cash in | 8.2% | 8.8% |
| Cap rate | 8.4% | 8.4% |
| 10-year IRR | 10.1% | 17.5% |
The cap rate is identical, because cap rate measures the house and ignores how it was paid for. Cash-on-cash return is nearly identical too, 8.2 percent against 8.8 percent, which surprises people who expect a loan at 7 percent to cost more than that.
It does not, because a mortgage payment is not all cost. Part of every payment pays down the loan, and that part is yours. At a 7 percent rate on a house earning an 8.4 percent cap rate, borrowing adds a little to the yearly return and a lot to the ten-year one. Cap rate against cash-on-cash return unpacks why those two percentages answer different questions.
What do ten years look like?
The IRR gap is where the real difference sits, and it comes from three things the monthly figure cannot show: the loan being paid down by the tenant, the appreciation earned on the whole $250,000 rather than on your share of it, and the smaller amount of money you tied up to get either.
Assuming 3 percent yearly growth in value, 2 percent rent growth and a sale in year 10:
- The cash buyer collects $230,054 of rent over the ten years and sells into $335,979 of value with no loan to pay off. Total, including the sale: $285,014 on $257,500 in.
- The borrower collects $70,381 of rent, and sells with $171,625 still owed. Total, including the sale: $153,717 on $57,500 in.
The cash buyer ends up with more money. The borrower ends up with a higher rate of return, because the same house did the same work against a quarter of the capital. With the other $200,000 the borrower could buy three more houses like it, which is the actual argument for financing. Whether they should is a separate question about how much risk they want running at once.
The borrower is also carrying a real obligation. This house covers its payments with room to spare, at a debt coverage ratio of 1.32, but the mortgage is due in a bad month as well as a good one. The cash buyer’s worst case is a house that earns nothing for a while. The borrower’s worst case is worse than that.
Can you get the cash back out later?
Partly, and there is a deadline. Fannie Mae’s delayed financing exception lets a cash buyer refinance without waiting out the usual seasoning period, but the new loan must be disbursed within six months of the purchase, and it cannot exceed the documented amount the borrower originally put in, plus the closing costs, prepaid fees and points on the new loan, subject to the normal loan-to-value limits on the current appraised value.
The guide also asks for a settlement statement showing no mortgage financing was used for the purchase, a title search showing no existing liens, and documentation of where the purchase money came from. If the cash came from an unsecured loan or one secured by another asset, the refinance proceeds have to repay it. Gift funds cannot be reimbursed this way at all.
Miss the six months and you are back to a standard cash-out refinance with its own waiting period, which the BRRRR refinance seasoning rules cover.
What does a lender make you keep in reserve?
If you finance instead, expect the reserve requirement to eat into what looked like spare cash. Fannie Mae measures reserves in months of the qualifying payment on the subject property, and an investment property typically needs six months’ worth.
Own other financed properties and there is more: an additional 2 percent of the combined unpaid balances for one to four financed properties, rising to 4 percent at five or six. Those reserves are not spent, but they are not available for the next down payment either.
Which one fits you?
Cash if the monthly income is the point, if you want the house to survive a bad year without a lender involved, or if you are near the end of buying. A loan if you are still building and the same money should be working on several houses.
The one thing that does not decide it is which number looks bigger. $1,751 beats $420 every month and still ends up the lower return.
Put your own price, rent and rate into the rental calculator, run it once with a loan and once without, and compare the cash-on-cash figures rather than the monthly ones. How much money you need to buy a rental covers what either route asks for at closing.