Full Disclosure Finance

By Justin

I have been examining some more real estate deals lately and am back in a situation where I am debating putting 5% down to get into a deal with lots of upside.

This may or may not be a great idea. As part of my due diligence, and to learn from my past experiences, I want to analyze my potential rates of return with varying down payments.

The basic principle for mortgage insurance on investment properties still applies: Do your best to only borrow 80% of your loan value from your primary lender. Use a combination of your down payment and another source for the other 20%. This will avoid mortgage insurance in the first place. However, this is not an option for everyone. We don’t all have friends and family or a large line of credit to borrow from.

Here’s the key data on the place:

Purchase Price:$250,000
Closing Costs: 2.5% of purchase price
Initial Investment for Renovations: $10,000
Maximum Potential Selling Price in 6 months: $300,000

Expenses for Sale:
Real Estate Fees (5%) = $12500
Mortgage Penalty for Early Sale = $1500
Misc (Legal / Insurance) = $900

Alright, so I first analyzed the Cash on Cash Return resulting from a purchase with varying down payments.

• Cash on Cash Return = Annual Net Income / Down Payment

Some people also include closing costs and renovation expenses in the denominator. This will decrease your Cash on Cash Return, which is fine because COCR is only useful for comparison. For this example, my net income included all estimated expenses (taxes, utilities, insurance, mortgage).

The breakdown is as follows:

As you can see, a lower down payment results in a higher COCR. Despite the higher mortgage payment and lower monthly net income, putting less money down gives me a higher rate of return.

This favours a long term hold approach where there are no clear plans to sell.

Lesson 1: If you plan on holding for a while, favour a lower down payment.

Next, I examined a potential quick sale resulting from some renovations to increase the value. These renovations would be performed either way, but I would have the option to sell if I choose.

I analyzed varying down payment amounts with the sale. I also altered the length of sale because this would influence the amount of cash coming in (from rent) and the return on investment.

The chart clearly shows that ROI is reduced with both time and a lower down payment. This contradicts the COCR analysis because the highest return comes from a high down payment. The time component is obvious because, even including appreciation of the property, when the shorter sale’s profit gets annualized its multiplier is relatively large.

Lesson 2: If you plan on selling quickly, and will be paying mortgage insurance, a higher down payment is best.

Now I have two lessons to guide my investment property purchases.

I will work to unify these two approaches to allow for a “governing” principle over down payment amounts. However, I think this is a good start and it will guide my decision making over the next few weeks with regard to this property.