Bought rental property in cash. What do I do now?

Question

I recently bought a two-unit rental property in cash. I bought it because it is the house next to mine, it was in bad shape and the former landlord offered a pretty good price.

The house was in such bad shape that I couldn't get mortgage for it. (I tried and the bank wanted many more repairs than the seller was able to do.) Buying in cash was my only option.

I've fixed the problems with the house, and should now be able to get a mortgage on it. I'm wondering whether I should do that, or should instead leave all of my cash in the house.

Conventional wisdom seems to be that it is dumb to tie up cash in investment properties. On the other hand, the house is currently fully rented, and my annual profit on the house (after factoring out money for taxes, maintenance and other expenses) from the rents should be about 10 percent of the purchase price annually.

To me, 10 percent is a pretty good rate of return for a relatively low-risk investment. (And I'm not even counting appreciation of the value of the property, because I know that's a bigger question mark.) It's almost certainly better than I could get in the stock market.

I suppose other real estate investors would mortgage the property, then use the cash they get out of it to buy other investment properties, presumably with mortgages. In theory, if I get a mortgage that lets me turn 80 percent of the value of my existing rental property into cash, I could go and buy four more houses (at 20 percent down each) in the same price range as the rental I already own.

However, that seems riskier. Getting a positive cash flow from any rentals would be much more difficult if they are mortgaged. I'd basically be dependent on appreciation of the properties in order to build significant wealth from them, and that is a risk. I'd also worry that if I lost my job, or had several tenants move out at once, I'd have trouble making the mortgage payments on all of the rentals.

So, to me it seems wiser to stick with a ~10 percent return on the money I've already invested in one rental than to go out and buy several more that will probably yield little to no liquid returns. (I'm also not eager to have to manage several more properties.) Does this make sense, or am I being a dumb investor?

By the way, I have plenty of personal savings, my personal home has no mortgage and I basically have no debt. (I say "basically" because I have some small student loads that are currently in deferment, so I won't pay them till they come due.) So I don't have much else to do with the money currently invested in the rental property other than invest it somewhere else.

Answer 1

positive cash flow from properties that are right next door is a great place to be. Well done. If you got a good price and you maintain the properties to a level that attracts good renters (good = responsible, pay on time), then you're making the right decisions.

Getting a mortgage on a property simply leverages your assets. With any leverage, there is risk. I prefer to minimize risk while maintaining positive cash flow. You're clearly not dumb. Sounds like you're on your way to being wealthy.

Answer 2

Obviously getting a mortgage on the property means you pay interest, which cuts into your profits for that property. If you rent it for 10% of its value and have a 5% mortgage, then your net return is only 5% (IF it stays rented). Sure, you can buy another property, invest it, whatever, with the goal of getting a better return.

Suppose you bought another property equal to the first property's value (which is not realistic since you'd want to avoid PMI, but it makes the math cleaner). And you rent it out for a 10% profit as well. Your return goes from 10% on one house to 15% on two houses (since the mortgage eats 6%). However, the risk has increased significantly.

Here's the risk of mortgaging the property:

You now have a fixed expense that's supported by a variable income. What if your tenant moves out suddenly and it takes you months to find another one? Do you have enough cash or other income to maintain the mortgage if you have no rental income? What if you have to replace the A/C or repair faulty plumbing?

Can you do it? Sure - but you have to be sure that you account for the risks involved. Keep 6 months of mortgage payments liquid (not in stocks or CDs) to make sure you can weather any storm.

Does this make sense, or am I being a dumb investor?

NOT borrowing money to invest is NOT dumb. Some investors can tolerate that kind of risk while others cannot, but it is not dumb by any means. In fact, many would say that investing borrowed money IS dumb (not just mathematically, but for other reasons).