Buy with cash.
I once, briefly, thought that was the way to go, but I see now that it’s more complicated, and more interesting.
So, today we are talking about when to spend cash for a real estate investment, and, more importantly, when not to spend it.
We will cover two situations, and answer the spending question for each one.
Not to be a spoiler, but the answer to one is “always,” and the answer to the other is “never.”
I’ll show you when, why, and how, for both.
Let’s get started.
BUY YOUR HOME WITHOUT CASH
Let’s clear up two things.
First, we are not talking about trying to invest in real estate with no money, like everyone is telling you that you can do. You can’t. Real Estate Professionals use cash, personal or borrowed, to purchase property.
Second, your personal residence is a Real Estate Investment, whether you choose to think that way or not.
Basically, it works like this.
You must have a place to live, and that means paying a certain amount of money to someone each month. (Unless you still live with your parents, or have moved back in with them.)
The amount of money that you will have to pay each month for a place to live will vary widely, depending on the part of the country.
And you might find a safe and comfortable residence for $1,250 per month.
But you are probably looking at $2,000 per month for something that fits your needs.
Suppose you are already a Real Estate Investor with single family rentals providing your income.
In order to get that amount of money in the first place, you would need three or four rentals to produce $2,000 per month.
Then you use the $2,000 per month to rent a property in which to live.
It makes no sense.
You could buy a personal residence (with a higher Fair Market Value than any of the rentals) for about a third of what it would cost you to buy the three rental properties, if you use a 3.5% down payment FHA loan.
And you could still buy the other two rentals, which would throw off more than enough cash to make your mortgage payments.
So, your personal residence is a real estate investment.
Plus, aside from that, it seems to me that if you can buy real estate, live in it for two years, sell it at a profit, and keep all of the profit up to $250,000 if you are single, and $500,000 if you are married, without paying any Capital Gains tax, or any other type of tax, under Section 121 of the Internal Revenue Code, then, friend, what you have here is a real estate investment. And a damned good one!
And if you are interested in learning how you can base your entire real estate investing career on buying personal residences, and easily end up being a millionaire, and probably a multi-millionaire, I recommend my book “Section 121 Real Estate Investing System” which is available in digital and print on Amazon.
If you would just like to read part of it first, for free, it’s available on this site. Just click the 3D Reader and read the first 52 pages. Contact me with any questions.
BUY YOUR HOME WITH CASH
And, although you can use very little cash to buy that personal residence, this is the one situation where it might be wise to use as much cash as you can.
And here’s why.
The residence is one of your personal assets. It is an item on your Balance Sheet. Part of your Net Worth. Where you store your wealth.
Think of it as your fall-back.
If everything else goes South, you will still have your home.
Even if you have to go through Bankruptcy, you will probably not lose your home. The equity in your home will be safe. Therefore, the more equity you have in your home, the better off you are.
The Bankruptcy Law of your State, as well as the Federal Bankruptcy Law, will determine what happens, and you need to look at your State Law. But I know people who have been able to rebuild their lives after Bankruptcy, just based on the equity they had in their home.
And in the meantime, while things are still going well, if you need cash for a short period of time, a Home Equity Line of Credit (HELOC) loan is the easiest to get.
Having most of your wealth in your home is like having a pile of cash that no one can take from you, no matter what happens.
There have been millionaires with all of their wealth in business assets who lost everything when the business dynamics, or the economy, took a negative turn.
And that brings us to Investment Real Estate.
DON’T BUY YOUR INVESTMENTS WITH CASH
If you use cash to buy Investment Real Estate, not only are you subjecting your cash to uncontrolled and unpredictable risk, as I just explained, but you are failing to take advantage of all of the benefits available to Real Estate Investors, before you even start.
Keep thinking LEVERAGE and COMPOUNDING, and you will understand everything that you need to know about Real Estate Investing.
Here’s what I mean.
If you use $100,000 cash and a $300,000 mortgage to buy a $400,000 Duplex, and it appreciates the historical average of 6.7% each year, in four years it will be worth $518,463.
Your mortgage will have been paid down some, depending on the interest rate and the term of the note, but let’s say the amount of pay down amount is $21,537.
That leaves a note payoff of $278,463.
If you sold the Duplex, you would have Net Sales Proceeds, ignoring transaction costs for the sake of simplicity, of $240,000.
Your original equity was $100,000 and it is now $240,000 four years later.
That’s an annual increase of about 25%, compounded annually.
If you had paid cash for the $400,000 Duplex, you annual increase in value of your investment would be 6.7%.
25% annual increase with financing, compared to 6.7% annual increase with cash.
That’s the value of leveraging and compounding.
So, while the mantra is that you should put down as little as possible when you buy your residence and get the longest note available, there might be times when that applies.
But if you realize that your personal residence is a repository for your wealth, safe from confiscation, and relatively easy to tap into when you need it, you might consider doing just the opposite. Make the largest down payment that you can, and pay off the note as soon as you can.
But with investment property, the opposite is true.
Pay down as little as possible, and delay paying the remainder for as long as possible, because time is your ally.
You might even consider an occasional refinance of the investment properties, and using the cash to pay down the note on your personal residence. This would, in effect, be periodically harvesting your investment profits and locking them away in your personal residence, where they are still available to you, but not to anyone else.
Just be sure that you structure the purchase and ownership so that you can either walk away from the asset if you have to, or you can tap into your personal wealth to cover a negative cash flow or unexpected expense.
I touch on this same concept in more than one of my books, but the one with the most detailed information is Chapter 4 of “Do This, Not That!” and you can find it here on this website. Use the 3D Flip Reader to look at the Contents and read the first few chapters.
The paperback is available on my Amazon Author Page, along with my other books.
And I have related Articles about real estate investing and other real estate matters from other perspectives on my LinkedIn Page.
I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.
If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange as part of your investment strategy, then you will really appreciate the value of what we are talking about, and I have a lot of material for you to consider on my S1031 Exchange website.
You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography. Here’s mine.
If you are interested in exploring my Catalog of Real Estate Investing books, but don’t know where to start, I suggest these three.
DISCLAIMER: I am an Attorney licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia. But I am not your Attorney. I would be honored if I were, but I am not. Reading this Blog does not created an attorney-client relationship between us. Internet content should not be used as a substitute for the advice of a competent Attorney admitted or authorized to practice law in your state or jurisdiction.