Is it better to rent out the less equity I have?

Question

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.

Answer 1

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.

Answer 2

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.

Answer 3

"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.

Answer 4

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.