Recently i worked with an investor who withdrew from buying a great one bedroom condo that he was going to use as being a rental. He withdrew because he was going to have negative cash flow the first few years that he owned the property.
What really surprised me about the situation is that the investor was buying the condo with a no-money-down loan and despite placing none of his own cash in the property; he still expected to break even right from the start!
This really is kind of like buying a cow for the milk products, but not being willing to feed her!
The same goes with buying small local rental properties, (the kind of properties that an average person could afford).
If you were to make a 30% down payment on a local rental property, (the kind of down payment the banks might want on an investment property) you would likely get a small amount of good cash flow right from the start.
However , if you buy an investment property with a small down payment or any down payment, you should expect to have to “feed” the property during the first few years associated with ownership. This is not necessarily a bad matter.
Consider the purchase of a $200, 000, single family home with 4 bed rooms and 2 bathrooms that could be leased for $1400/month.
Here is what could happen once you make a large down payment, and what may happen when making a small down payment or no down payment:
Example #1: A huge down payment & positive cash flow:
“Joe Investor” makes a 30% down payment ($60, 000) when buying his two-hundred dollar, 000 rental home. This leaves Dude with a mortgage of $140, 000.
At a 6. 5% interest rate, Joe’s monthly payment with taxes and insurance plan would be about $1110 (PITI). Let’s take an assume maintenance and vacancy costs of $170/month. Joe’s total regular monthly cost of owning the property would be $1280/month.
The difference between the rental income associated with $1, 400 and the expenses of $1280 gives Joe $120 within monthly positive cash flow.
If the house went up in value 2% the first year, Joe will have made $4, 000 in appreciation + $1, 440 in total positive cash flow. Total profit: $5, 440
Joe’s total first year return on the $60, 000 he invested would be: $5, 440 ÷ $60, 500 = 9%
Example #2: No down payment, and some negative cash flow:
“Jane Landlady” has great credit score, but not a lot of cash, so she decides to buy her $200, 000 house for rent with no money out of pocket. Her mortgage payment is $1, 489 per month (PITI).
Like Joe, Jane also has vacancy and maintenance expenses of $170/month.
Jane’s total price of owning the home is $1, 659 per month. Jane is receiving $1, 400 per month in rent.
Jane needs to take $259/month out of her pocket to make up the difference between the price of owning the property and the rental revenue she receives.
Jane’s rental home also goes up in value 2% ($4, 000) during the first year.
Jane’s total investment into the home is usually $259 for 12 months, or $3108.
Jane’s first year return on her cash investment: $4000 ÷ $3108 = 128%.
Needless to say, Jane is very happy about this.
Jane will probably have several years of negative cash flow before she can raise the rents high enough to cover her expenses.
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The good news is that her return upon invested dollars (the “negative” cash flow) will always be dramatically higher than Joes.
P. S. What if Later on & Jane both stop making payments on their rentals due to being unable to get their homes rented? That will be the first person the bank forecloses on?
Not Jane, she has hardly any equity. It would cost the bank money to take back (“foreclose on”) and resell Jane’s rental home.
Poor Dude though, the bank wants his rental house bad. There’s lots of equity within Joe’s rental home. The bank isn’t going to lose a dime foreclosing on Joe’s rental house
Joe manages to lose his rental home to foreclosure and Joe kisses his good credit score, goodbye.
Jane’s no down payment strategy has bought her a little extra time and that might be just enough time to let her save her credit plus save her rental home from foreclosure.