A few times a week I talk to investors planning on putting a large down payment on the purchase of a single-family rental home. The goal is to have a better “cash flow”. It may sound logical – the greater the down payment, the smaller the loan, and hence the monthly payments. However, the foundational piece of buying rental homes in the United States is the “gift” called “the 30-year fixed rate loan”. This loan sounds like a miracle to most foreigners, since neither the monthly payment nor the mortgage balance EVER keeps up with the cost of living around the world, while everything else does.
The magical 30-year fixed rate loan
The 30-year fixed-rate loan is at the heart of life transformation for investors when the homes are held for 10 years or more (preferably over 15). The loan keeps getting eroded by inflation (or CPI– the cost of living), while the home, rent, and everything else keeps requiring more dollars to buy (hence in dollars, their value goes up – even without intrinsic appreciation). The 30-year fixed rate loan starts looking quite puny after 12, 14, 16 years. It may be years before it is paid off, but since it never keeps up with the cost of living, inflation hammers the real value of the loan.
These loans are a great financial gift, with future-changing potential. Why, then, would you want to make the gift smaller? Especially at today’s low rates? The answer is, you don’t. A larger down payment will mean the magical loan will be smaller.
May be wise not to exceed 20% down payment
This is not fully utilizing the power of the fixed-rate loan, and it means the borrower has expended more of their scarcest resource: cash! Even very wealthy people, who can afford to put down a large down payment or buy for cash, choose to put down less money. They do this to leverage their cash with the 30-year fixed-rate loan.
I think that in normal cases, a 20% down payment should not be exceeded. The small additional cash flow due to having a smaller loan is insignificant at the present time. Right now, your main “cash flow” should come from your own earnings (salary). It is later in life during retirement that the rental homes can replace your income.
In cases of big 1031 exchanges, with not enough properties to identify, or in cases of not being able to get the FNMA loan anymore, then larger down payments are merited and that is a different blog post. I still think the down payments should be less, rather than more, in any circumstance. Currently, in our Membership area on our website, we have podcasts and a webinar that discuss loans and cash flow in depth. You can learn more about it at icgre.com/members
Also on the pro side, people are confused as to where money should operate. The knee-jerk
reaction is to have money sit as cash (with close to zero yields). However, when people are scared of stock markets, real estate and (especially) single family homes usually become more interesting as a safe hard asset that produces income, which we tell our clients at ICG as well.
What does it look like these days?
You can talk to many borrowers who have taken 30-year fixed-rate loans and after, say, 16 years, realized that although there are 14 years remaining to pay off the loan, the loan balance AND the payment seem very low relative to the marketplace rents and prices. The remaining 14 years is almost meaningless since in many cases (statistically and historically) the loan balance will be a small fraction of the home price and not very “meaningful.” Just to get some perspective, most other countries on earth have loans that constantly adjust based on inflation. Both the payment and the balance track inflation all the time, usually with no yearly and lifetime caps as adjustable loans have in the U.S.
From a historical perspective, these are extremely low rates. Most experts think that in the future, mortgage rates will rise; from a historical perspective, even 7% is considered a low rate. Thus, these days, you can “turbo boost” the great power of the never-changing-30-year fixed-rate loan by also locking in these amazing rates which will never change. If in the following year’s interest rates indeed go up, you will feel quite good about having locked under-5% rates forever.
Some would say that the 15-year loan is also better since it has a better rate. True, the 15-year rate maybe 0.25% or even 0.5% better than the 30-year rate. However, in my opinion, this is not enough to justify the enormous loss in flexibility. In addition, having the loan for a longer time allows inflation to “erode” the loan even further. This last consideration greatly minimizes the argument some investors make that “…with a 30-year loan I pay hundreds of thousands of dollars more over the life of the loan.”
One factor missing here is that they neglect the TIME VALUE OF MONEY! These extra dollars paid in year 20, 22, 28, etc., are in fact extremely “cheap” dollars in the sense that their buying power is greatly lowered over time. If the value of these future dollars were to be calculated based on the PRESENT buying power of the dollar, some of the later payments may be worth mere pennies on the dollar.
In summary, I recommend getting a 30-year loan and then choose how long to take to pay it (anywhere between zero and thirty years – you choose!).
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As a busy professional, it is likely that your income will be sufficient to qualify for loans on investment properties – especially Single Family Homes – in most of the U.S. markets. A high percentage of busy professionals also have good credit scores, which bodes well for getting good financing.
I maintain that the ideal property for real estate investment for the busy professional is the Single Family Home (SFH). SFHs are almost a perfect property for the individual investor who also has a regular job or business. SFHs are still the “American Dream” for most people. They are also a relatively attainable dream in many large metropolitan areas in the U.S. where prices are quite affordable, even in 2016.
SFHs are essentially the “liquid” real estate since when it is time to sell your potential buyer pool is the largest – effectively all home-buyers in the marketplace. These homes are the real estate investment on which you can get the most powerful loan in the real estate universe – the magical fixed-rate, 30-year loan.
Technically this loan is available on 1 to 4 residential units so duplexes, triplexes, and four-plexes also qualify. However, SFHs are usually superior to 2-4 unit properties. In good areas, you will usually find only SFHs, while you may have to travel to another part of town to see the “plexes” and they will usually be surrounded by many other “plexes.” The “plexes” are more likely to present management challenges, have more short-term tenants (statistically) and to top it off, may not necessarily provide as good an appreciation over the long term.
One exception is new duplexes in white-collar areas, but overall the SFHs are superior. I have been buying homes for well over 30 years and helped people buy nearly 10,000 homes in dozens of markets. During these decades, I have witnessed many “plexes” and their performance as well as many thousands of SFHs. My experience and the experiences of thousands of investors leads me to favor the SFHs over the “plexes.”
Buying larger residential properties – apartment complexes – can be a good investment, but there are areas where the investor needs to be an expert. The optimal apartment complex size, based on the experience of most apartment complex investors, is between 100 and 300 (many say 150-300) units, so economies of scale can be utilized to improve cash flow.