Hey guys, welcome back. Mat here again with Key Renter Tulsa, available always at 918-351-7000 or keyrentertulsa.com. Today we’re going to be talking about how to finance a rental home for the greatest return. Of course, there are a number of things to consider when you’re going to actually finance a rental property.
The first thing to consider is your credit. The better your credit, obviously the better the rates are going to be that you get from a lender, the more comfortable they feel that you have the ability to pay back that loan. If you don’t have great credit, you might consider partnering with somebody that does. Taking 50% of a deal is better than taking zero of no deal, or 100% of no deal. Think about partnering. Same for available cash. If you have great credit and you have a great opportunity to buy something, consider partnering with somebody to get the cash. If you have it, all the better.
Consider that your investing goals might be different and might lead you down a different path. For example, if you’re a cashflow investor, you might be considering one opportunity to be the better opportunity … Sorry. One loan opportunity, the amount of money you’re going to put down or the interest rate or whatever else. If you’re an appreciation player, you might consider something else. Also, keep in mind that every deal is different. If you’d like to get more specifics on the deal that you’re working on, give us a shout. Give us a shout anytime at 918-351-7000 and we can run you through the proforma of a rental property and we can actually make it specific to the deal that you’re looking at.
We’re going to do a case study today and we’re going to talk about what happens if you buy something that’s all cash, if you buy at 50% leverage, meaning you take 50% from the bank and you put in 50% cash, 25% down, 20% down, or 15% down. The numbers are going to change dramatically when you go through these under time. The assumptions that we use are going to be the same for every case. We’re going to have a purchase price of $200,000 and rents of $1,600 a month.
The assumptions are going to be that we have a 10 year hold time, and therefore the rents will be averaged out to $1,600 per month. That means that they’ll be a little bit lower in year one but much higher in year 10. 3% annual appreciation, which is standard for our market here in Tulsa. 3% annual rent and cost inflation, which again is a fairly conservative assumption and pretty standard for our market. Then the average tax, operating costs, vacancy, etc are all going to be the same, held constant as a proportion of our revenue number from rent, which in this case is $1,600 a month averaged out. All that stuff will remain the same, and here we go.
If we buy this thing for cash, what does that mean? It means we purchased $200,000, the purchase price, it means that we’re going to put down $200,000. The rents will be the same, $1,600 a month. We have no principle and interest payment and we, of course, have no interest rate because we’re paying all cash. If you look at the all cash purchase over a 10 year average, what you have is $1,149 of cashflow per month. You have 6.7% return on your cash from the rental income, and you have a 9% cash return after the sale.
If you look at 50% down, that means we’re going to take a 50% note on the property and we’re going to take 50% of our cash. We’re going to pay, again, $200,000 for the property. We’re going to put $100,000 down. The rents remain steady at $1,600 per month. This means that we’re going to pay interest of 4.25%. Of course, you qualify for special rates if you put down a big chunk of equity or cash down into the property, and so we’ve done that.
Now, keep in mind that I’m doing this video early February of 2018 and these rates are going up. I think the prime interest rate right now is 4.5%, so this is a little bit low given where we stand, and interest rates are slated to move up still. If you’re watching this video at some point in 2018, later in 2018 or 2019 the interest rates could be significantly higher than this. Still, for the sake of our exercise, we’re going to put them at 4.25%. That means you’re going to pay $492 per month in principle and interest, and held over 10 years you’re going to have almost $660 of monthly cashflow. A rental return, cash on cash return of 7.4% and 11.9% cash return after the sale. A little bit better than if you were doing an all cash deal.
Now, if we look at 25% down, which means you’re going to put $50,000 down into the property, same purchase price of $200,000. The rents, again, are remaining constant at $1,600 per month averaged out over 10 years. What you see now is interest rates are still the same, because as long as you’re putting down more than 20% or 25% in some cases you get preferential rates. We’re going to pay $738 per month in principle and interest. Of course, more than we did in this scenario because we have taken out a larger loan, of course. At these numbers, 25% down you’re going to see 10 year average annual returns that look like this, $411 per month of cashflow. Return on your cash from rental income of 8.8% and then return on the sale on your cash of 17.2%. The numbers are looking better.
What happens if we go to 20% down? The purchase price is $200,000 still of course. That means we’re putting down $40,000 into the property and taking a note of $160,000. $1,600 rent standard, and the interest rate has gone up a little bit. You’ll see you don’t qualify for the low interest rate because you have less equity going into the property and that means a little bit more risk for the lender, whoever’s lending that property should there be a depreciation in the property itself, there’s more risk that the loan will go bad. You’re going to be at 4.5%.
Now your interest and principle payment, PI as we call it, is $787 a month, similar actually to what you see at 25% down. Just a little bit more, and it’s reflected here. This cash return on the rental income is going to be the same. You’re going to have a little bit less cashflow per month, but of course you’ve got less money in the deal, so your cash on cash return will be the same. Cash return after sale is a little bit higher.
What if we go to 15% down payment? In this case, it looks like $30,000 down on the same purchase price and with the same monthly rental income. What you see here in the principle and interest category is that you’re going to pay more in principle and interest, because of course your outstanding loan amount is much more. In addition, because there is greater risk that the lender or the bank is taking, you’re going to have to pay mortgage insurance of $125. Now, this could be variable, but generally speaking that’s a fair amount to assume.
Your interest rate is going to be higher because it’s a lot riskier in the case that you only put 15% down, because if the property depreciates a little bit or loses value, the haircut is going to go … That could naturally take 15% out of the property value and all of a sudden the bank has to take a haircut on their loan, which they don’t like to do so they’re going to charge you more interest rate, that reflects the higher level of risk associated with that loan.
What does that look like in terms of your 10 year average annual return? We’re talking about cashflows just eking by, $89 a month over the 10 year hold period, which means in the first couple of years in this investment you’re going to lose money, you’re going to lose cashflow and have to pay money into the property every month. Over the long term over the 10 year horizon you’re going to make some at the end, and it averages out to a small monthly cashflow amount. It means your cash return on the rental income on your original cash is going to be 3%, much lower than other points that we’ve seen in this presentation. Then, also your cash return after sale is slightly lower than it was at 20%, at 16.1% here.
If we just do the comparison, what we see is that cashflow is going to steadily go down as we borrow more money, because more money is going to have to be contributed towards the principle and interest payments. The return is going to increase slightly, but then come down a little bit on the annual cash on cash return from your rental. This is kind of the sweet spot if you see here and over here, because you’re paying mortgage insurance and you’re paying so much in principle and interest, you’re going to have very little cash on cash return from the rental income.
25% or 20% down is kind of the sweet spot of where the returns really exist, and that’s kind of the conventional practice when you take out a loan. That’s really where most people would choose to take out money from a bank. That’s the conventional side that can be sold on a secondary market of course, and therefore you’re going to get great long term rates. You’re going to lock in something for 30 years, 20 years, whatever you prefer. Those of course can be sold in the secondary market. The 10 year, the return on your cash at sale is going to be again in the sweet spot right here in 20, 25% down. Some people are happier with lower cash on cash returns every year or month but higher annual returns when they annualize out a return, and that could be appreciation, it could be some other stuff. Again, the 15% down is a little bit lower than other spots, particularly in our sweet spot here.
I encourage you to come by and have a chat with us at some point. We can run your property or your deal through the proforma rental analysis spreadsheet that we have and we can look at a bunch of things related to the property from the perspective of both an investor, which of course we are. We’re owners here in Tulsa. We own a number of single family and multifamily properties.
Also, not just from the investor perspective but also from the property manager’s side, we’d like to make sure that when you’re doing your analysis you’re taking into account a number of expenses that may fall by the wayside when you’re doing your analysis such as vacancy rates, property management fees, unexpected maintenance and other things that should be accounted for to make sure we’re not over-inflating the returns and that you would see kind of disappointed numbers in the long run in reality vis a vie what you projected at the beginning.
Anyways, come by, have a chat with us any time you’d like or shoot us mail at [email protected] or give us a shout 918-351-7000. Until next time, thank you very much. Mat with Key Renter Tulsa.