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Suppose I have a property with a certain amount of equity, with the rest on a mortgage, and I want to know if I should sell it or rent it out.

I can think of three scenarios. I'm not considering valuation, devaluation, taxes or fixed costs (closing, etc.) for simplicity.

Scenario 1: I sell the property, pay off the mortgage, and invest the rest (the equity I had built) in a diversified portfolio. I can generally know what my expected long term return is. Of course, the less equity I have, the smaller the investment will grow.

Scenario 2: Fast forward time a few years. I paid off the mortgage, and I'm renting out the property. I can calculate the growth percentage very easily, and compare it to investing in my general portfolio to see if it makes more or less sense to sell or rent out.

Scenario 3: I start renting before having paid off the mortgage. Supposing I can get rent for more than the monthly payment of the mortgage, the renter is basically paying out my mortgage, building equity for me, and I have some money left. This difference is fixed every month, so every month it's a smaller percentage of the equity I have, which is growing every month.

And that's basically it. It doesn't matter how I look at the numbers, I see that the less equity I have, the greater the percentage on my investment I get!

If I could theoretically convince my bank to give me a 100% loan with no upfront payment, and let me pay only the interest, I could get an infinity% return on my investment, since I'm getting a non-zero return on a zero investment.

Of course, this is impossible, but the numbers suggest that the lower the initial payment, the lower the monthly payment, and the less of the rent money that goes to equity, the greater the return on my investment is.

Is this right, What's the flaw in my analysis? Even though the numbers paint a story, I find it a bit counterintuitive that the less money (equity) I have, the larger the return.

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    What are you going to do with the house if you don't rent it out?
    – glibdud
    Aug 9, 2021 at 11:49
  • glibdud: sell it. That's scenario 1. Aug 9, 2021 at 11:50
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    Please know that you will be working for the rents. Owning real estate is hardly passive income.
    – Pete B.
    Aug 9, 2021 at 18:31
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    An interest-only loan is not eternal. You need to pay back the money at some point, which will come from either putting the money from the rent aside (and then you are paying a lot more interest than you would with a regular amortised mortgage), or by selling the property before the end of the loan, which of course may be a problem if the market crashed in the meantime. And in between, you still have to pay interest, whether the property is actually rented out or not, whether the tenant actually pays or not. And pay taxes, and pay for maintenance...
    – jcaron
    Aug 10, 2021 at 8:51
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    I would also like to point out that the faster you pay off the mortgage, the sooner you begin to keep the lion's share of rent payments, or have the freedom to lower rent on the property.
    – Raven
    Aug 10, 2021 at 19:49

4 Answers 4

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Yes, the less you put in the greater your return, but the more risk you have. Less equity means you have a higher debt balance (by definition), which means a larger debt payment. So if you can rent it for more than the mortgage (and taxes, insurance, repairs, etc.) and if you have a renter every month, then yes you can come out ahead. But there's risk in all of that. Suppose it goes unrented for 6 months? Suppose you need to lower the rent to keep it rented and have to make up the difference on your mortgage payment. Suppose the A/C goes out and you need to pay thousands of dollars to replace it?

All of those situations can happen regardless of whether there is a mortgage, but having a mortgage increases your risk by requiring a payment every month regardless of whether or not you have income. So not having rent income for 6 months might force you to sell (or miss payments and let the bank foreclose).

You're essentially borrowing money to invest, which increases leverage, which multiplies returns in both directions. So gains are bigger, but losses are bigger as well, which increases risk.

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  • I don't think leverage is really applicable to the scenario you've described. Yes, leverage means that the loss is greater if the value of the house decreases and they want to sell. But it doesn't increase the loss in the event of a sudden expense or loss of income. The real challenge is the effect of the mortgage on cash flow, not leverage.
    – Daniel
    Aug 10, 2021 at 0:40
  • Thanks for the explanation. My understanding of leverage is that it doesn't increase risk, but it increases spread. That is, I have more to gain, but more to lose, but the average is the same as without leverage. I don't understand how the math applies in this case. Can I ask you to elaborate a bit more, with numbers if possible? Aug 10, 2021 at 2:31
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    @Daniel it also affects leverage. If I buy a $200k house by borrowing 50%, then my profits are increased relative to my investment.
    – D Stanley
    Aug 10, 2021 at 2:45
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    @PandaPajama Risk is typically measured by the variance of returns, not average return. A coin flip where I can either lose everything or double my money is "riskier" than one where I either win or lose 1%, but both have a "zero" expected return.
    – D Stanley
    Aug 10, 2021 at 2:50
  • @DStanley granted, but that's different from the argument you've posted here. The answer here is about cash flow.
    – Daniel
    Aug 10, 2021 at 3:01
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7 years ago, I bought a 3 family house (i.e. a building containing 3 rental apartments). US$180,000 cost after purchase and full renovation.

I funded this by writing a check out of my HELOC (home equity line). I could have done the math with your approach, where I take today's current value and cash flow, and divide by zero, congratulating myself on an infinite gain. But that would be ignoring what is actually at risk. For me, it was my own equity, a loan secured against my house. In your case,

If I could theoretically convince my bank to give me a 100% loan with no upfront payment, and let me pay only the interest

this is key. If you could somehow do exactly this, set up as a non-recourse loan, i.e. if things go south, the bank doesn't come after you, you will stand to make a riskless fortune. Or at least, riskless to you. Either way, the fact that you have nothing at risk doesn't quite make the return infinite. To your math, the idea of dividing by the equity, I suppose you are right, that it's best to have the highest ongoing loan, interest only for maximum leverage. It's this leverage that makes investing in rental property far more profitable than purchasing one's own home, if only for the fact that rental apartments tend to have far less space than a house in the suburbs.

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  • Thank you for your reply, and for sharing your experience. I'm not sure I understand the point you're trying to make. Are you saying my analysis is correct? is it incorrect? Aug 10, 2021 at 2:29
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"Ownership" can be divided into two types: equity, and debt (the term "debt" is a bit confusing, since owning debt is the opposite of having debt). You, the house owner, have equity ownership. The bank, who owns a lien on your house, has debt ownership. The ratio between equity and total value is called "leverage". As leverage goes up, the risk of equity ownership in absolute value decreases (they have less money invested for them to lose), but the risk as a percentage of investment goes up. This decrease is absolute risk is shifted to the debt owner; their risk goes up, and so the return they expect generally goes up as well. So what you may be finding counterintuitive is that the return as a percentage of stake goes up. However, the absolute amount of income will go down the less your equity is.

The more leverage increases, and the less and less the equity owner has invested, the debt position becomes more and more like just owning the asset outright (that is, a debt owner who has supplied 99% of the equity is in a position that's very close to bein an equity owner with no debt). In corporate finance, stocks are equity ownership, and bonds are debt ownership. When a company is highly leveraged, its bonds are called "junk bonds". Junk bonds are very risky, but can have high returns.

The smaller the down payment, the higher the interest the bank will demand. Mortgages are generally recourse loans, which means that if you default and the equity isn't enough to pay off the loan, the bank can go after you for the remainder, so it's not quite the case that if you have a down payment of 0, your ROI is infinity; the amount of money you're risking on the investment isn't just the down payment, but also your other assets that could be seized. If you do have a no-recourse mortgage, a bank would be foolish to allow you to not make any down payment.

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This question puts the cart in front of the horse. Financing should not be the driver of your investments.

Instead, consider if you can rent the place profitably, considering not only financing costs, but minor and major maintenance costs, taxes, fees, the value of your time working as a property manager, and vacancy costs.

Even if not profitable, you still might want to speculate on rising real estate prices if the monthly loss is small. Only by running the numbers can you know where you stand.

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  • Thanks for your response. However, I'm not asking for advice -- I'm just stating a semi-theoretical point, and I want to understand the math behind my reasoning. Aug 10, 2021 at 2:28
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    Leverage magnifies both gains and losses. See r/wallstreetbets for real-life illustrations. Aug 10, 2021 at 15:40

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