Cash on Cash Returns for Rental Properties

Financial Place Online test fired their “Complete Landlord Calculator” today.  The first test involved what is referred to as “Cash on Cash” return.  The “Cash on Cash” return is the percentage of annual cash received vs your initial investment.  This is an important return as it defines how your investment cash flow looks.  A negative return indicates that the house is sucking up money.  Higher positive returns can be had with better management of the underlying financials such as interest rate, purchase price, and rent received.  A higher rate can also be had by increasing the amount of leverage of your investment capital.

Leverage of Capital:  The ratio between your invested capital and the purchase price of the asset.  In the case of a $50,000 investment and a $50,000 purchase price, the leverage is 1:1, or more simply expressed as 1.  However, if the investment was $5,000 for the same $50,000 asset as would be done through using the bank’s money to cover the other $45,000, the leverage would be 10.  A higher leverage will return a higher rate of return for investments who return a rate greater than the weighted averaged cost of borrowing.

The problem with using leverage is that negative returns get exaggerated in the same way.  This deals with both cash flows and a decrease in value of the underlying asset.  Using the $50,000 asset with a leverage of 10, a $5,000 drop in value wipes out all of your investment, since the bank still needs to be paid.  In most all cases, the bank has secured the loan by your asset, so they will be the first to be paid in case you have to sell.

The below chart shows an example case of “Cash on Cash” returns plotted against the amount invested.  The investment being examined has the following characteristics:

  1. This is a house priced at $150,000
  2. Your out of pocket closing costs are $1,500
  3. The mortgage is for a 30 year term
  4. The interest rate is 4%
  5. The rents collected is $1200
  6. Property management takes 10% of rents collected
  7. Occupancy rate is 95%.  Many rental markets are on fire right now
  8. Property taxes at $1500 per year
  9. Hazard insurance is $300 per year

Cash on Cash>>> The chart shows a very high rate of return in the case of 0% down (just the $1,500 closing costs).  From here the rate of return decays exponentially until it flattens near 6.5%.  This amount is the unleveraged rate of return.  Again, remember that too much leverage can be dangerous.  In the case of residential real estate, a healthy amount of leverage can be had between 10% and 30%, and will vary from opportunity to opportunity.  There was entirely too much dealing done during the sub prime era of real estate lending where 0% down deals were permitted on rental properties.  The highly leveraged cash flows swung to the negative after the crash and many investors did not have the cash on hand (which is why they did 0% down) to cover the losses, and thus lost their businesses.

 

How does a reverse mortgage work? What determines the payment amount?

A reverse mortgage is a financial product using your existing primary residence as collateral.  The borrower must be at least 62 years of age in the U.S.  There are various ways the cash flows can be worked in a reverse mortgage.  The product is similar to the annuity.  One type of a reverse mortgage is where you “sell” your house today for monthly payments of a certain amount and remain in the house until your death.  The part of remaining in your house is what is different than an annuity.  In the case of an annuity, you won’t have access to the funds used to purchase the annuity once it’s purchased.  In addition, a reverse mortgage is not considered a sale, by standard sales definitions.

The key part of a reverse mortgage is staying the fact that the borrower will be staying in the house as their primary residence.  It is part of the terms and conditions.  Moving, selling the house, or dying all bring the loan due.  A reverse mortgage is also heavily loaded with fees.  Origination costs of 2%, upfront insurance of 2%, and your effective rate of borrowing are all higher than other products using your house as collateral.  The good news, is that there is a way to emulate the reverse mortgage using other financial products.

A reverse mortgage can be approximated by taking a “cash out refinance” on your house and using the proceeds to buy an annuity.  Using our previous example of an annuity of $100k paying $6250 a year:

  1. The homeowner has a house worth $100k and is completely paid off
  2. The homeowner takes out a $100k cash out refinance (or home equity loan) with interest only payments
  3. The $100k is used to purchase the example annuity
  4. The homeowner receives $6250 a year from the annuity, but must pay the cost of the cash out refinance
  5. The interest only payments at 3% would be $3600 a year
  6. Your net income from an arrangement equivalent to a reverse mortgage is $2650 a year or about $221/month.

There is one small concern on the above arrangement.  Interest only mortgages are not particularly common.  It is more likely that this arrangement would be worked with a 30 year mortgage instead, and the extra amount in house payment would start to build equity back into the house.

This arrangement can also be worked between a variable home equity line of credit and a variable annuity.

 

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