If you are new the real estate market, you may be asking yourself how much cash you need to properly become an investor. Many people will repeat the saying that “cash is king,” without fully understanding the pros and cons of dealing solely in cash payments.
As you enter the exciting world of real estate, you should consider the following when it comes to cash:
Benefits of using cash
Cash on hand is definitely important when you own a property because it is often necessary to cover unexpected expenses, such as repairing a sudden leak. It can be essential to keep some of your money liquid, so that you are prepared for the hidden pitfalls you may encounter as a property owner.
You may also opt for cash payments because, although it may be difficult to gather the money, you can use it to invest more quickly. Instead of having to go through the lengthy process of securing a loan, you can simply close on a place right after the home inspection is complete. Qualifying for a loan often entails finding a lender, qualifying for a loan, and the receiving the money needed; paying in cash, on the other hand, can be completed within one day.
Cash payments for properties may also often secure you a fantastic discount. Many sellers will be attracted to your ability to immediately close on the property instead of having to wait for you to find a lender and get approval. Because of this, you will have the leverage to negotiate a discount or other favorable terms.
In addition, if you purchase a property without using a loan, you will never have to worry about making mortgage payments; this means, if you have a vacancy, you won’t be hemorrhaging money. When your property is vacant, you do not run the risk of “running in the red.” You also save the money you would have spent on the interest payments that come with a mortgage. Additionally, investing in property with cash means that all the money your tenants pay for their rent is yours to keep. You can also sell your property and make instant income without having to worry about paying back a lender.
Furthermore, dealing in cash may provide you with the additional financial security you desire. With cash, you have access to your money wherever you want it, whenever you want it. Although there are many pitfalls associated with using cash, the added security can be extremely attractive.
Disadvantages of using cash
Obtaining a loan to purchase a property is often much easier than using cash, especially if you are new to the rental market. For the majority of property investors, gathering enough cash to purchase a $500,000 home is unrealistic. It is much more practical to find a lender that is willing to cover the difference. You can leverage a loan to purchase higher quality properties that you would have otherwise not been able to afford if you simply paid in cash. Buying a better property means you’ll be able to charge higher rents and make more money than would be possible in a property purchased with cash.
It is also relatively easy to obtain a bank loan to purchase a property, unlike many other loans. With the proper down payment, you are likely to be approved for a mortgage to purchase the property you’re eyeing. Because the process is so easy to navigate, there is little reason to avoid going this route.
2. Attraction to sellers
In addition, although you may be able to get a discount on investment properties using cash, most sellers will be willing to wait for a bigger payout that comes with a buyer using a mortgage. While cash payments are clearly faster, the time saved is usually not worth a loss of thousands of dollars to the seller. Despite having less leverage to negotiate, purchasing with a loan makes it more likely that the seller will accept your bid for the property.
3. Ability to take risks
Cash payments may also make you less stressed about making your debt payments each month, but it will also keep you from taking investment risks. Because you’ll only be willing to invest in properties you can afford with your cash, you are more likely to select lower quality properties. Conversely, with a loan, you can leverage the cash you do have to purchase a property that provides a larger income.
Large cash savings are usually a bad idea because when your money is just sitting in a bank, it accrues very little interest (usually less than two percent per year). These interest rates are a fraction of the percentage of inflation each year, meaning that you actually lose money when it simply sits in the bank as accessible cash. In a strong market, investments can properly combat investments and ensure that you make money each year.
While there have been dips in the real estate market from time to time, such as during the latest recession, the market moves upwards in general. In the last 70 years, the real estate market has consistently increased, indicating that it is a stable place to put your money rather than leaving it in a bank to depreciate over time.
5. Tax Risks
You may have trouble keeping track of all of the cash coming into and out of your property if all you deal in is hard cash, which means you are at greater risk of being audited by the IRS – something everyone wants to avoid. Cash can also lead to accounting errors, meaning there may be something for the IRS to find during the audit.
In addition, mortgage interest can be deducted from your taxes, while the same cannot be said for cash payments, which have no tax-deductible elements. This tax deduction can be very advantageous to you, so it’s something important to consider when deciding if you’ll deal solely in cash.
What’s the alternative to cash?
The alternative to hard cash is cash flow, which is the net amount of money that flows into and out of your businesses each month. Cash flow provides you with lines of credit that you can then use when you want to purchase an additional property or make an additional investment; this means relying on cash flow gives you additional freedom that regular cash simply cannot provide because you can stop worrying about how much money you have sitting in the bank and instead focus on the quality of deals you close.
There are two ways to calculate the total amount of your cash flow. The first formula is as follows:
Rent – Principal, Interest, Taxes, and Insurance (PITI) – Estimated Annual Costs = Cash Flow
This formula essentially calculates your cash flow by subtracting your cash out from the cash you receive in. However, you may be unsure of how much you will be receiving in if you have yet to determine how much you will charge for rent. Therefore, there is an additional way to calculate your cash flow and rent by working backwards.
First determine how much you would like to make each month. For example, you might purchase a property and want to make approximately $150 each month. From this initial amount, add your estimated annual costs along with PITI. The final number is how much you should charge each month for rent. The formula looks like this:
Rent = Desired Cash Flow + Principal, Interest, Taxes, and Insurance (PITI) + Estimated Annual Costs
While you might be inclined to use the second formula, it may give you a number that is unreasonable for the area of the property. For instance, if the formula finds that you must charge $2000 a month, but all other comparable rental homes cost $1200, you cannot reasonably charge this high amount. Additionally, you also run the risk of underestimating your total annual costs and charging too low for rent.
Whatever strategy you use to calculate your cash flow, you must do so in order to obtain a loan from the banks. Lenders will use your cash flow amount to calculate how to underwrite your loan, so it is important to understand this concept and have a number prepared.
The bank will use what is called a Debt Service Coverage ratio (DSC) to determine how much debt you can take on. In general, the majority of banks require that you make a minimum of $1.20 in positive cash flow for every $1 of debt you receive; this is a DSC of 1.20 and is the typically minimum a bank will require. With this in mind, you must know what your cash flow will be when you apply for a loan.
The bottom line
Although you may be tempted to conduct your business dealings solely in cash, or hoard any money you make in the bank, dealing in hard cash is ultimately an unwise business decision. You can use loans and cash flow to leverage the money you do have to make additional investments and increase your income.