Cash Purchase VS Mortgage

Finance, the study of valuing investments, is based on three principles: people prefer to have more money than to have less (greed), people dislike risk (risk aversion), and people want their money as soon as possible (time value of money). Based on these, an investment is more desirable if it offers more returns, has guaranteed profit, and the returns come soon. These three principles affect the prices of stocks, bonds, and commercial real estate. The latter has the peculiarity that we can ask for attractive loans by offering the property as a collateral. This is called a mortgage. It has been observed that there is a relatively high amount of debt in real estate investments when compared to other industries (Panasian, Seiler, and Harrison). The more tangible the collateral is, the easier it is to increase leverage (Giambona, Golec, and Schwiembacher). The same thing cannot be done in the stock and bond markets because their prices can reach 0 if the company issuing them goes bankrupt or defaults, respectively. In real estate, however, the land never depreciates. This means that a property always has a value because the land will always be there (unless it sinks like Atlantis or something) and can be used for other purposes. It turns out that it is beneficial for investors as well to almost always ask for mortgages when investing in real estate.

Most people I know prefer to make all-cash purchases when investing in real estate. This is usually suboptimal because the returns are simply equal to the cap rate at the time of purchase. The rate of return would be a small percentage of the value of the property. However, if the property was purchased when the cap rate was very high—which is uncommon (based on my limited observation)—the income will be equally high. In fact, the inflation (which in the US is low) will push rents upward, which will increase the owner’s wealth over time. Also, the investor would not owe anything. This is less time spent on paperwork, money spent on bank fees, and hustle when finding tenants to pay back the loan. Nevertheless, the value of the asset would completely depend on the market. No individual can influence it, which makes it risky. The investor’s wealth would be dependent of an entity that he or she cannot control. An all-cash purchase promises relatively low returns and is risky since its value does not depend on the investor. It is not the most efficient way to make money in real estate.

If an investor, instead of making an all-cash purchase of a property, offers that same amount as a down payment for a mortgage, the rate of return will be higher. For this to be true, however, the property’s cap rate must be sufficiently higher than the loan’s interest rate. If this condition is not met, the loan payments may exceed property’s net operating income, which will result in a loss. In the United States, the normal industry condition is for the cap rate to be higher than interest rates making mortgages ideal.

For example, suppose you have $200,000 you want to invest in real estate and the cap rate is 8%. You can buy a property worth $200,000 and receive $16,000 a year (8% of 200,000). The alternative is to offer the $200,000 as a 20% down payment for a $1,000,000 property. Suppose that the loan has an interest rate of 6% a year (APR) and is a 30 year mortgage with monthly payments. Under this conditions, the loan payments would be $57,556.85 a year (I calculated this with a financial calculator).

Because the cap rate is 8%, the property’s net operating income would be $80,000 per year. Of this amount, you need to pay the bank your monthly payment, so your real return is (80,000 – 57,556.85) $22,443.15. Notice that this amount is higher than the $16,000 you would be getting with an all-cash purchase. You would receive $6,443.15 more per year!

There is catch, though. The property must have low vacancy to get the most of the investment. If there is empty space, the bank takes most, if not all, of the income. Moreover, high vacancy or tenants that do not pay may cause the owner to be unable to pay the bank. Yet, at least, this is a risk the owner can control by choosing the right property, location, tenants, and manager/real estate agent. Also, a larger property with more units has less vacancy than a property with fewer units (Guasch and Marshall 226). But, what about the market risk?

Interestingly, a mortgage provides a sort of hedge, or protection against market fluctuations. This is a little more difficult to see. The loan payments have two components: (1) interest and (2) amortization. As the loan is paid, the principal amount, or the amount owed, is amortized, or reduced. During the first years, the amortization is almost negligible, but as time goes by, the interest portion is lower and the amortization is higher. The cool thing about this is that, after a few years, when the owner decides to sell the property, the cash he or she will receive is much higher with a mortgage than a cash purchase even if the value of the property is significantly lower than that of the time of purchase. This is best illustrated with an example:

Suppose that ten years have passed since the example above. One investor, let us call him Brutus (picture on the right), purchased the $200,000 property all-cash, and you purchased the $1,000,000 with the mortgage. How would each investor be affected if the market reduced prices by 10%? As a side note, in real life the property’s price would change based on the cap rate and not change based on a percentage, but for simplicity purposes I am stating it this way (the result will be the same). When Brutus sells his property, he will only get $180,000. Notice that he invested $200,000 and experienced a $20,000 loss due to the market price reduction. On the other hand, your property's price went down by $100,000 (10% of $1,000,000). Did you lose more? Well, no. When you sell yours, you will get the selling price minus the amount you owe the bank. After ten years you would owe the bank $686,499.07 (I calculated this with a financial calculator). You would get $900,000 (the property price) – 686,499.07 (the price owed to the bank) = $213,500.93 (the cash you get). Remember that you only invested $200,000. Even if the property’s price went down by 10%, you received more money with the sale than what you invested whilst Brutus lost money due to the price reduction.

This happens because the rents have been amortizing your loan. Your tenants have been paying for your property all along and you did not have to put a penny. The tendency for real estate is to go up in the long run at an average of 5.3% (Investopedia). This is not necessarily true for the short and middle term because the market fluctuates. A mortgage will offer a protection against these fluctuations.

An all-cash investment in real estate offers less hustle when finding tenants and less paperwork hassle, but offers little returns and has high market risk. On the other hand, a mortgage is more tedious to get with all the paperwork, but offers higher returns, provides a hedge, and transforms market risk to vacancy risk, which the investor can administer. Instead of worrying about what the market is going to do—which cannot be controlled—investors can manage their properties effectively to make all their payments and receive higher profits. As long as the cap rate is higher than interest rates, a mortgage is better than an all-cash purchase.

Works Cited

Giambona, Erasmo, Joseph Golec and Armin Schwiembacher. "Debt capacity of real estate collateral." Real Estate Economics (2013). Online.

Guasch, and Marshall. "An Analysis of Vacancy Patterns in the Rental Housing Market." Journal of Urban Economics 17.2 (1985): 208-29. Web.

Panasian, Christine A., Michael J. Seiler and David M. Harrison. "Further evidence on the capital structure of REITs." Real Estate Economics (2010). Online.

Investopedia. "Investopedia." 2017. Commercial Real Estate. Web. 20 December 2017.