Math Class – Case Studies in Financing Rental Property
I am going to use a house that I own in Springfield to illustrate the cost and benefits of financing a purchase. First I am going to show you the numbers if I had paid cash. Here is the return on investment analysis:
| Murray Street – As Cash Purchase | ||
| Single Family Home | ||
| Purchase Price: | $25,000 | |
| Rehab: | $0 | |
| Total Investment | $25,000 | |
| Potential Rent | Monthly | Annually |
| Unit 1 | $550.00 | $6,600.00 |
| Unit 2 | $0.00 | $0.00 |
| Total | $550.00 | $6,600.00 |
| Vacancy Reserve 10% | -$55.00 | -$660.00 |
| Repair Reserve 20% | -$110.00 | -$1,320.00 |
| Insurance | -$40.00 | -$480.00 |
| Property Taxes | -$48.00 | -$576.00 |
| Interest Expense | $0.00 | $0.00 |
| Water | $0.00 | $0.00 |
| Trash/$18 Per Unit | $0.00 | $0.00 |
| Mowing/Average Over 12 Months | $0.00 | $0.00 |
| Professional Management 10% | -$55.00 | -$660.00 |
| Total Expenses | -$308.00 | -$3,696.00 |
| Net Profit | $242.00 | $2,904.00 |
| Estimated Appreciation: | 0.00% | |
| Annual Return on Investment: | 11.62% |
| In Springfield, I Look For 15% ROI |
My ability to buy this house via land contract was the main reason I compromised on my 15% default goal. I paid $25,000 and it had a tenant in place at closing. I agreed to a $2,500 down payment and a mortgage of $22,500 at 10% over 10 years. This meant a monthly principal and interest payment of $296.
Loans Cost Money and Negatively Impact Return
From a profitability perspective, the interest I pay becomes an expense and negatively impacts my return. As you can see below my ROI drops from 12.10% to 6.38% with the added interest expense factored in.
To simplify this example, I am averaging the total amount of interest I will pay over the ten year period. In reality, the interest peaks during the first year and steadily declines over the remaining term until the last few payments are almost all principle. (Bankrate.com has a great mortgage payment calculator that allows you to print amortization schedules based on whatever parameters you choose.)
| Murray Street – With Interest Expense | |||
| Single Family Home | |||
| Purchase Price: | $25,000 | ||
| Rehab: | $0 | ||
| Total Investment | $25,000 | ||
| Potential Rent | Monthly | Annually | |
| Unit 1 | $550.00 | $6,600.00 | |
| Unit 2 | $0.00 | $0.00 | |
| Total | $550.00 | $6,600.00 | |
| Vacancy Reserve 10% | -$55.00 | -$660.00 | |
| Repair Reserve 20% | -$110.00 | -$1,320.00 | |
| Insurance | -$40.00 | -$480.00 | |
| Property Taxes | -$48.00 | -$576.00 | |
| Interest Expense/Average over 7 Year Term | -$109.00 | -$1,308.00 | ① |
| Water | $0.00 | $0.00 | |
| Trash/$18 Per Unit | $0.00 | $0.00 | |
| Mowing/Average Over 12 Months | $0.00 | $0.00 | |
| Professional Management 10% | -$55.00 | -$660.00 | |
| Total Expenses | -$417.00 | -$5,004.00 | |
| Net Profit | $133.00 | $1,596.00 | |
| Estimated Appreciation: | 0.00% | ||
| Annual Return on Investment: | 6.38% | ||
| ① Total interest over the life of the mortgage is $13,031.35/120 months = $108.59 per month. |
Cash Flow Suffers Even More
Now let’s look at how having a mortgage on this property affects my cash flow. Financing negatively impacts my cash flow because I have to pay the total amortized payment of $296 a month out of my gross income. The interest portion of each payment over the term of the seven-year loan is expensed while the principal portion of each payment is part of my profit.
| Murray Street / Cash Flow Analysis | ||
| Single Family Home | ||
| Purchase Price: | $24,000 | |
| Rehab: | $0 | |
| Total Investment | $24,000 | |
| Potential Rent | Monthly | Annually |
| Unit 1 | $550.00 | $6,600.00 |
| Unit 2 | $0.00 | $0.00 |
| Total | $550.00 | $6,600.00 |
| Vacancy Reserve 10% | -$55.00 | -$660.00 |
| Repair Reserve 20% | -$110.00 | -$1,320.00 |
| Insurance | -$40.00 | -$480.00 |
| Property Taxes | -$48.00 | -$576.00 |
| Total Monthly Mortgage Payment, Principle and Interest | -$296.00 | -$3,552.00 |
| Water | $0.00 | $0.00 |
| Trash/$18 Per Unit | $0.00 | $0.00 |
| Mowing/Average Over 12 Months | $0.00 | $0.00 |
| Professional Management 10% | -$55.00 | -$660.00 |
| Total Expenses | -$604.00 | -$7,248.00 |
| Free Cash Flow Until Mortgage is Paid Off | -$54.00 | -$648.00 |
| Estimated Appreciation: | 0.00% |
I Am Actually Losing Money
As you can see I am planning to be upside down from a cash flow perspective as much as $648 a year on this property. I am comfortable with this possible worst case outcome but so far I have had no vacancies and my repair expenses have been minimal. Consequently, I am breaking even on this property and have yet to put to put any additional cash towards it to keep it afloat.
Financing Made Sense For Me
Financing this property made perfect sense for me. I was able to buy a house I did not have the cash for and at the end of a 10 years I will own it out right. I structured the deal so that if I do find myself in a negative cash flow position my exposure is limited. There is also room to raise the rent another $50 to $75 a month after this tenant moves out, and in all likelihood, I will pay the mortgage off early. In my opinion this is how an investor should utilize financing.
The Cost of Financing a Side By Side Double
Here is another property that I financed:
| Center Street / As Cash Purchase | ||
| Side By Side Double | ||
| Purchase Price: | $20,000 | |
| Rehab: | $43,125 | |
| Total Investment | $63,125 | |
| Potential Rent | Monthly | Annually |
| Unit 1 | $550.00 | $6,600.00 |
| Unit 2 | $550.00 | $6,600.00 |
| Total | $1,100.00 | $13,200.00 |
| Vacancy Reserve 10% | -$110.00 | -$1,320.00 |
| Repair Reserve 20% | -$220.00 | -$2,640.00 |
| Insurance | -$60.00 | -$720.00 |
| Property Taxes | -$26.00 | -$312.00 |
| Interest Expense | $0.00 | $0.00 |
| Water | -$35.00 | -$420.00 |
| Trash/$18 Per Unit | -$36.00 | -$432.00 |
| Mowing/Average Over 12 Months | -$35.00 | -$420.00 |
| Professional Management 10% | -$110.00 | -$1,320.00 |
| Total Expenses | -$632.00 | -$7,584.00 |
| Net Profit | $468.00 | $5,616.00 |
| Estimated Appreciation: | 0.00% | |
| Annual Return on Investment: | 8.90% |
This property is comparatively superior to most of the other properties I own. It is also in a neighborhood that has been easy for us to rent in. I initially bought the house for $20,000 on a 7-year land contract and sat on it for almost 3 years before rehabbing it. The house had new vinyl siding, a new roof and all new windows but it was just bare studs inside. It cost me an additional $43,125 to make it habitable over the course of a year.
How I Did It
I did over-improve this property to some degree but I did a quality job and I expect it to outperform my portfolio over the long term. By the time I started the project I had opened a line of credit at a local bank secured by a couple of properties I owned free and clear. I used the line of credit to rehab the property. Once it was completed, I financed the property with a $33,800, 15-year mortgage at 5% interest. I used the proceeds to pay down the line of credit.
By The Numbers
Here are the numbers including the average monthly interest expense. Like with the Murray Street property, I averaged the total amount of interest I will pay over the 15 year / 180 month term of the mortgage. In reality, the interest peaks during the first year and steadily declines over the remaining term until the last few payments are almost all principle.
| Center Street / With Interest Expense | |||
| Side By Side Double | |||
| Purchase Price: | $20,000 | ||
| Rehab: | $43,125 | ||
| Total Investment | $63,125 | ||
| Potential Rent | Monthly | Annually | |
| Unit 1 | $550.00 | $6,600.00 | |
| Unit 2 | $550.00 | $6,600.00 | |
| Total | $1,100.00 | $13,200.00 | |
| Vacancy Reserve 10% | -$110.00 | -$1,320.00 | |
| Repair Reserve 20% | -$220.00 | -$2,640.00 | |
| Insurance | -$60.00 | -$720.00 | |
| Property Taxes | -$26.00 | -$312.00 | |
| Interest Expense/Average over 15 Year Term | -$79.51 | -$954.12 | ① |
| Water | -$35.00 | -$420.00 | |
| Trash/$18 Per Unit | -$36.00 | -$432.00 | |
| Mowing/Average Over 12 Months | -$35.00 | -$420.00 | |
| Professional Management 10% | -$110.00 | -$1,320.00 | |
| Total Expenses | -$711.51 | -$8,538.12 | |
| Net Profit | $388.49 | $4,661.88 | |
| Estimated Appreciation: | 0.00% | ||
| Annual Return on Investment: | 7.39% | ||
| ① Total interest over the life of the mortgage is $14,311.88/18 month = $79.51 per month. |
Cash Flow Analysis
The cash flow analysis for this property shows that worst case, I should have positive flow.
| Center Street / Cash Flow Analysis | ||
| Side By Side Double | ||
| Purchase Price: | $20,000 | |
| Rehab: | $43,125 | |
| Total Investment | $63,125 | |
| Potential Rent | Monthly | Annually |
| Unit 1 | $550.00 | $6,600.00 |
| Unit 2 | $550.00 | $6,600.00 |
| Total | $1,100.00 | $13,200.00 |
| Vacancy Reserve 10% | -$110.00 | -$1,320.00 |
| Repair Reserve 20% | -$220.00 | -$2,640.00 |
| Insurance | -$60.00 | -$720.00 |
| Property Taxes | -$26.00 | -$312.00 |
| Total Monthly Mortgage Payment, Principle and Interest | -$267.08 | -$3,204.96 |
| Water | -$35.00 | -$420.00 |
| Trash/$18 Per Unit | -$36.00 | -$432.00 |
| Mowing/Average Over 12 Months | -$35.00 | -$420.00 |
| Professional Management 10% | -$110.00 | -$1,320.00 |
| Total Expenses | -$899.08 | -$10,788.96 |
| Free Cash Flow Until Mortgage is Paid Off | $200.92 | $2,411.04 |
| Estimated Appreciation: | 0.00% |
Cash on Cash Return = 15.9%
Another way to evaluate this property is to look at its ‘cash on cash’ return. I have roughly $29,325 of my own money in this deal. The bank started with $33,800. My net profit after interest expense is projected to be $4,661.88 annually. (See Case Study #8) Taking the net profit of $4661.88 and dividing it by the $29,325 I have in the deal equals a cash on cash return of 15.9%. I really like owning this property.
Care To Learn More?
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