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Why Buying Real Estate With Cash Is Actually Riskier Than Getting A Mortgage

By Gregg Cohen

I came across another ridiculously good article today and I gotta pass it along to you.  It comes from the Bawld Guy Talking Blog, an incredibly informative blog about the financing world of real estate.  In fact, one of our mortgage brokers on our team at JWB Real Estate Capital – Chad Emerson – is a regular contributor to the blog.  If you want to stay up to date with the latest movements in the mortgage industry, you should definitely subscribe to this blog (you can do so by clicking here.)

So,  yesterday Bawld Guy brought up a scenario in his blog that we often see with our investors who want to invest in real estate.  Many have enough cash in the bank to do it without a mortgage, yet we still encourage them to finance the property.  Think that's taking on unnecessary risk?  Well, read the article and then I'll give you my two-cents on why buying real estate with cash is actually riskier than getting a mortgage:

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Attention Real Estate Investors – Buying For Cash? You May Wanna Rethink Your Strategy

Written By  Bawld Guy (To read the full post on the Bawld Guy blog, click here)

Then the cash buyer said, “Yeah, but I get immediate cash flow, no debt service, and no worries. Top that!” “But” I retort, “There are at least a couple major, built-in flaws to that strategy for many using it to acquire income property.” “This oughta be rich” he came back, sarcastically. He was dodgin’ my special brand of smack after comparing results using my tactical modification to his strategy. To his horror, I was makin’ sense. (A fleeting smile crosses his wife’s face, mostly in her eyes, and is gone as quickly as it came.)

Rich indeed

Let’s take a look at a common scenario — and build a profile based upon my experience with these kinds of buyers. We’ll purposefully remain in the middle of the road with all financial factors describing him.

Age — 51

Job — Earns $190,000 a year plus the occasional bonus.

Lifestyle — Lives almost up to their kneecaps. Owes a bit over $100,000 on the home in which they’ve lived the last 18 years — has a market value of roughly $500,000 these days.

Bank info — Has $250,000 burnin’ a hole in their pockets and can’t wait to write checks for distressed properties. They have more, of course, but their comfort level stops at that figure.

Savings/Retirement Plan(s) — $500,000 and change in CDs. $25,000 in checking. $700,000+ in a self-directed IRA. A free and clear BassKiller on which he wants his Viking Funeral when he’s gone. :)

What he wanted to do

He’s been researching a few markets, especially those allowing him to buy homes for $80-125,000 apiece. Location is important of course, but he knows he can’t require anything approaching ‘A’ for those prices. Most of the rents he’s seeing in that price range are about $750-1,150 monthly. The price/rent ratios vary, but he’s not been surprised — either way. He’s found a couple SFRs (single family residence) he can buy — $105,000 and $100,000 — both in what he calls ‘upper blue collar’ neighborhoods. That’s a new one on me.

They rent for $925 and $900 a month respectively. His analysis says his cash flow after all expenses/vacancies should total about $1,200 monthly, a figure with which I disagree, but nonetheless accept. Both homes were built in the middle 80′s and are in good condition. Together they cost him about $208-210,000 to close, including all costs. He’d of liked to have found three, but he refuses to spend more than $250,000 — AND doesn’t feel comfortable with cheaper homes.

Since he’s gonna retire in nine years, he knows these properties will be contributing roughly $14-15,000 a year to his retirement income. 35-50% of that, give or take, will be tax sheltered about 15 years into his retirement. Between his job’s pension, Social Security (:)), and the income his IRA will generate (he hopes), he feels fairly comfortable. I don’t.

My plan

The budget allocates $250,000 spent to generate a basket of income from income property. However, since I have a fairly well defined timeline in which to work, about nine years, I’ve devised a plan that will far exceed the results his plan provides.

Location Applying the BawldGuy MomRuleIf I wouldn’t put my soon to be 80 year old mom into the property to live alone, don’t call me about puttin’ my clients into it. — automatically means the properties he’d acquire in my plan would be way better located than are his. It’s not close.

The key modification

I’d have him acquire three, not two income properties which would require him to take on some debt. In this case, they’d be putting about 30% down payments while borrowing the balance at a 30 year fixed rate of 5.75%. Even using more punitive operating expenses/vacancy rates relative to what he used in his scenario, my cash flow is still about 17% higher than his — $1,200 vs $1,405 monthly. And no, that’s isn’t a big deal, but it’s better. He tried to appear unamused. Furthermore, I rounded down quite a bit on my properties’ cash flow even after inflicting higher holding costs.

He’s made it clear that during those nine years they can easily and painlessly add not only all the cash flow from these three properties, but contribute an additional $2,500 monthly towards the elimination of all three loans. He’ll be applying the BawldGuy Domino Strategy.

All cash flow, plus his monthly $2,500 contribution will be applied to just one property’s loan. That one gets paid of in 40 short months. The cash flow rises magnificently. They then turn their sights on the second property in the same manner, but this time they’re adding even more to the loan payment due to the freshly debt free first property. The second property is rendered debt free in just 31 months. The third property has no chance. :) In a mere 25 months it’s also added to the free ‘n clear ranks. All three dominoes are down.

They will have done this in eight years, leaving them a year’s cushion. It’s methodical in nature, and vanilla simple by design.

His plan yields an annual income of about $14-15,000.

Mine? The annual income from those properties will be approximately $54-56,000 yearly.

Gee . . . I dunno. Should they flip a coin to decide which plan to choose?

BawldGuy Takeaway: Even if his plan had allowed him to buy SEVEN of those homes for cash, they’d STILL arrive at retirement with less cash flow than my plan generates. ‘Course, we’ll ignore the reality that it woulda taken almost triple the capital he’d allotted in his plan. We’ll also ignore the fact that he didn’t have that option anyway, as he didn’t have the over $700,000 in cash it woulda required.

Let’s pile on — why not?

His net worth (only the properties) using his approach will be just over $200,000 when he retires.

If he opts for my strategy? His net worth will be a tad over $3/4 Million.

Is he screamin’ Uncle! yet? No? OK, he asked for it.

If the economy goes to hell in a hand basket, cutting my suggested properties’ cash flow in half, but (go with me here) miraculously leaving his homes untouched? My way STILL crushes his cash flow by over 80%. AND, if simultaneously my properties’ value are cut in half? His net worth going my way REMAINS barely under 85% greater than his — even if his didn’t lose a dime in value.

What was that? Did I just hear an Uncle!? I think I did.

Paying all cash for properties — if there’s a viable alternative allowing the use my strategy — isn’t always the be all end all it’s touted to be.

Just sayin’ . . . The above was another example of what genuine Purposeful Planning can accomplish. There’s no substitute for having an intelligent plan and executing it on purpose.

I need a freakin’ fix — which you can provide by simply calling me at 619 889-7100. We’ll figure out together where you are now, and what’s possible for you down the road. Have a good one.

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This is one of the best articles I’ve read it a long time when it comes to the advantages of taking on a manageable amount of debt service in order to reach your long-term financial goals. We come across this scenario with our clients a lot and many clients are scared to death of taking on debt, even if it limits their ability to reach their goals. They are afraid of the risk of having a mortgage, but in reality they are taking a much greater risk in my opinion…the risk of not reaching their goals!

Now, I am not recommending that everyone jump on the American bandwagon and mortgage themselves to the hilt in order to get a higher rate of return.  What we are searching for here is MANAGEABLE DEBT.  The kind that your cash-flowing property will cover on a monthly basis….and the kind that you can afford to cover should there be maintenance, vacancies or evictions (which WILL happen if you invest in rental properties).

We constantly coach our investors to make sound, objective buying decisions based on two factors: 1. Our relationship and 2. The numbers of the deal.  That's it.  And when it comes to the numbers, the way you finance a deal has the ability to make it a good deal or a great deal.  Don't let your fear of debt limit your chance of reaching your financial goals on the timeline you've set for yourself.

 

Gregg Cohen is an owner of Progress Home Buyers and JWB Real Estate Capital, one of the country's largest home buying and residential redevelopment companies.  In the past 5 years, he and his team have bought and sold close to 250 deals and is on pace to complete 120 deals in 2011.  He speaks nationally to crowds of thousands of real estate investors with his mentors, Than Merrill & Paul Esajian of A&E "Flip This House,"  has been featured multiple times in the Florida Times-Union and the Jacksonville Business Journal, and he was also a member of the Board of Directors for Jaxreia from 2009 – 2010.  To receive 30 days of free real estate education from Gregg and his mentors, please visit www.provenprofits.com or call our office at (904) 677-6777.

 

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