In a previous posts, we discussed how measuring the cash on cash returns are a better way to measure the profitability of an investment than using the Capitalization Rate alone. Today we are going to discuss how using bank financing to leverage as many properties as possible compared with a single cash purchase can dramatically increase your cash on cash return.
Americans love borrowing money. We use our credit cards when we go out to eat. We never save up to buy a car. According to the Statistic Brain Research Institute, nearly 70% of Americans have a mortgage. Many families are so in-debt that they are consistently one or two paychecks away from foreclosure. While many types of debt are detrimental to the borrower, using the bank’s money to purchase more income producing properties is a justifiable and even recommended way to increase personal wealth.
Check out how this example shows how leverage can increase your cash on cash returns:
As you can see from this example, the Cash-on-Cash returns for the financed property is nearly a full percent and a half higher than if you paid for the whole property out of pocket. Even though the cash purchased property will earn the investor $7,200 per year, they will only be earning a 6.3% return on the $115,000. Whereas paying only 20% of the purchase price upfront will earn 7.7% and leaves an additional $92,000 to invest.
If you had $115,000 in cash to spend on real estate (not including closing costs for the sake of simplicity), you could only buy one property if you pay cash. But how about if you finance each purchase – assuming the purchase price for each property is $115,000?
So, instead of purchasing just one home for $115,000 which earns $7,200 annually, you can own five rental properties for the same amount of out of pocket money and earn a total of $8,820 a year. All of this is possible by leveraging every investment. Even though each property has a mortgage payment, owning five properties with a mortgage turns out to be more profitable than one property without. On top of that, you now have five properties appreciating in value instead of just one.