Does it now make sense to pay cash for investment properties?

[ChpBstrd]

I found a freshly remodeled duplex in my city and ran the numbers (see attached). The property exceeds the 1% rule, looks nice with granite counters and new bathrooms, and is in a stable and quiet grade-C neighborhood of duplexes and small SFHs. Appreciation is not expected to be a significant factor. I have enough cash idling in 4.6% yielding US treasuries to buy the thing without a mortgage if I wanted to.

Assuming I could get a 6.5% mortgage (probably a low estimate, Zillow is offering 7% and a lot of websites show no offers), and the other assumptions on the spreadsheet, the total ROI amounts to:

Y1: 3.60%
Y5: 7.00%
Y10: 12.27%

If I set the down payment to 100% and change nothing else - not even estimated closing costs - the cash ROI equals:

Y1: 5.70%
Y5: 6.37%
Y10: 7.38%

The unleveraged ROI is higher in the short term and lower in the long term. Thus the decision to get a mortgage or pay cash for this duplex comes down to one's estimate about whether there will be rate cuts in the next few years. One would NOT want to get a 6.5% or 7% mortgage now, paying a couple grand for the privilege, only to refinance in 2 or 3 years when rates are much lower and get to pay those same costs again.

If rates fell significantly after one paid 100% cash for the duplex (like to 4.5% for example), one would mortgage the duplex to enjoy leveraged returns and be happy they did not pay the costs of getting a mortgage a few years ago when it was bought. Plus, in that world one might be glad to have tied up their money in a modest-yielding duplex rather than stocks, because a recession was probably the cause of the rate cuts.

If rates rise significantly, one might regret not getting a mortgage at a lower rate when that was possible. One might also regret tying up their money earning a 6-7% ROI from mortgage avoidance when treasuries now yield that much. It might now be uneconomical to extract one's money from the duplex using a mortgage. 

What are your thoughts? Am I misusing the spreadsheet? Has anyone changed their investment property buying behavior due to higher mortgage rates?

[SilentC]

Let me get back to you on this, I’m working on my own modeling would be interesting to compare notes. Edit - I’m thinking through the same issue and one thought is to use a 15 year mortgage to get the rate a little lower and then refi into a 30 year if rates come in. 

[SilentC]

Yeah the model has an error in it, I haven’t looked at it super closely but it didn’t make sense that the ROI was ramping that fast for the mortgaged property.  It is not adding the principal pay down as capital invested, in other words in row 46 it is only looking at the downpayment in the denominator.  If you own the house for 5 years for example you should have an extra $7k invested which will reduce your ROI.

I find it more informative, too, to look at IRR over a time period.  For me it’s more helpful to think that if I own a house for 15 years, have X cash flows and sell it at Y price in 15 years it will be a 6.5% annualized so I can better compare that to other investment alternatives where I think I might compound at 8% or whatnot.  You can do that with an IRR formula in Excel, might be worth googling how to set up an IRR calc.

Your assumptions did not look crazy.  If you or anyone wants to opine I’m wondering if a edit:3.8% per year rent growth assumption is too high on a 20 year investment in an $800k SFH in central Colorado burb?  I also have expenses growing slightly faster than rent because I think skilled repair/maintenance labor and materials cost will beat rent growth for $100k+ earners as all the affordable housing is disappearing.

Oh yeah, I also think the model is not taxing NOI for rental income, I get you can shield some of that with depreciation and such but another consideration to think about. Maybe the author of the sheet doesn’t include rental income in their tax return so not an error :)

[GilesMM]

It makes sense to pay cash for everything now if you think rates will fall soon and you can save refinancing costs by waiting.  If they don't fall as fast or as far as you think, you miss out.

[ChpBstrd]

Yeah the model has an error in it, I haven’t looked at it super closely but it didn’t make sense that the ROI was ramping that fast for the mortgaged property.  It is not adding the principal pay down as capital invested, in other words in row 46 it is only looking at the downpayment in the denominator.  If you own the house for 5 years for example you should have an extra $7k invested which will reduce your ROI.

Yes, I see what you mean. Strictly speaking the mortgage paydown is additional capital invested, because you could sell the property and extract that capital in any given year. So the amount of capital invested goes up each year. The money applied to mortgage paydown is not readily available for the LL's consumption.

Maybe the author of the sheet didn't want to create a loop by double-counting mortgage paydown as both ROI and capital investment, because capital investment is a component of ROI, and not counting mortgage paydown as ROI would seem to ignore most of the return?

Or maybe they were just trying to get as close as possible to math that would help them compare a down payment to buying a bond, on a total returns basis? Both of these are good reasons to do it like they did, even if in real life a LL ends up with ever-greater amounts of their money tied up in the property as time passes.

This is a feature of landlording I've not seen discussed very much. If I buy a corporate bond yielding 5%, I get 5% dumped in my lap each year in the form of cash. OTOH, if I buy an investment property earning 5%, some portion of my return goes into mortgage reduction and the remainder (if any) is provided to me in cash. If I want to obtain the cash from mortgage reduction, I must sell or refinance the property, paying potentially thousands in closing costs as a sort of ATM fee!

[SilentC]

Yeah the model has an error in it, I haven’t looked at it super closely but it didn’t make sense that the ROI was ramping that fast for the mortgaged property.  It is not adding the principal pay down as capital invested, in other words in row 46 it is only looking at the downpayment in the denominator.  If you own the house for 5 years for example you should have an extra $7k invested which will reduce your ROI.

Yes, I see what you mean. Strictly speaking the mortgage paydown is additional capital invested, because you could sell the property and extract that capital in any given year. So the amount of capital invested goes up each year. The money applied to mortgage paydown is not readily available for the LL's consumption.

Maybe the author of the sheet didn't want to create a loop by double-counting mortgage paydown as both ROI and capital investment, because capital investment is a component of ROI, and not counting mortgage paydown as ROI would seem to ignore most of the return?

Or maybe they were just trying to get as close as possible to math that would help them compare a down payment to buying a bond, on a total returns basis? Both of these are good reasons to do it like they did, even if in real life a LL ends up with ever-greater amounts of their money tied up in the property as time passes.

This is a feature of landlording I've not seen discussed very much. If I buy a corporate bond yielding 5%, I get 5% dumped in my lap each year in the form of cash. OTOH, if I buy an investment property earning 5%, some portion of my return goes into mortgage reduction and the remainder (if any) is provided to me in cash. If I want to obtain the cash from mortgage reduction, I must sell or refinance the property, paying potentially thousands in closing costs as a sort of ATM fee!

I think it’s just wrong.  Paying off $10k of mortgage principal is an investment of capital.  You can refi and get the 10k out obviously but it’s expensive to do so and there would need to be an accrual in the numerator to reflect that recurring cash out refi cost, and higher interest expense would happen at the same time.  I do take back comment about rental income though, I compare my investments on after tax returns but that’s not a rule to do so.

Edit - perhaps another way to think about this is if you get a $10k bonus at work and use it to prepay part of the mortgage, would you count that as invested capital?  I hope the answer is yes, and there is no difference between these $10k and another $10k the bank requires you to put in on an amortization schedule over X years.  The annual pay down amount should be included in both the numerator and the cumulative pay down in the denominator.