Did you ever wonder if you should put a large down payment on your commercial property purchase or as little as possible?

 

Start with the assumption that you have substantial cash to make a significant down payment - whether from savings or from a 1031 exchange. The question is whether you should take that entire amount and use it for one down payment on one property or could you use that money to spread among several properties to make several smaller down payments on several properties?

 

To answer this question, you start with several basic premises. First, real estate is an investment. Second, the money put into real estate cannot be used for other investments. Finally, if the investment in real estate is to be preferred over another investment vehicle, that real estate must produce value to you in greater amounts than the other potential investments.

Real estate can earn value for you in two ways - it can appreciate in value or it can generate rent. In either case, the return must be netted against finance charges if the full cash price is not paid. Thus, for a property that appreciates at 10% per year, if you had to finance the entire amount at (for example) a 6.35% mortgage, the net growth would be 3.65%. Of course, for anyone so lucky to have enough to buy the property in cash, the return would have been the full 10%. To simplify matters, assume that the property is worth $1,000,000 on the purchase date. The person who paid in cash has an investment worth $1,100,000 one year later. The person that had to finance the entire purchase price has an investment of $1,100,000 but has to pay $63,500 to get that investment for a net gain of $36,500. If the analysis were to stop there, the reader might assume (incorrectly) that the answer to the question is to put all of the money into a single down payment on a single property.

 

To stop the analysis there ignores the cash flow potential of real estate. Add to the equation that any potential property, in addition to appreciation, [earns] rent of 5% per year or $50,000 per year. This significantly changes the calculus because the person who spent his/her whole nest egg buying one property is earning $100,000 per year from appreciation but is only earning $50,000 per year from rent (for a total of $150,000). However, had that person taken his/her $1,000,000 and bought five $1,000,000 properties but financed 80% of each property, that person would be earning $250,000 that year in rent alone and would have had an additional appreciation of $500,000 - net of the $254,000 paid in interest that year (now would be a good time to mention that interest can be tax deductible and this number may be significantly lower).

 

"Sign me up!" is what most people would say. This is "leverage" - the ability for money to earn money even when you do not actually have that money. That is, for one buying five $1,000,000 properties with financing, that person actually has $5,000,000 working for him/her, not just the $1,000,000. But there's a catch (yes, there's always a catch). Aside from interest payments, real estate involves risks that other investments do not. Real estate returns are not easily calculable - just because a property appreciated 10% the previous year, does not mean it will again. While stocks face the same issue, investors can analyze other factors, such as price to equity ratios, that are not available for real estate. In either case, there are inherent risks.

So what is the answer to the initial question? Diversification. Diversification can occur in many ways, but buying multiple properties instead of a single property already provides an initial level of diversification. Second, not every person has the taste to put all of his/her money in real estate. For those people, diversification can include taking some money out of real estate and buying stocks and bonds. The latter are more liquid and can be easily sold in a pinch - whereas real estate can take months to sell. Not to mention, taking $1,000,000 and investing that money in the stock market does not require paying interest, but then again, it's not leveraged.

 

At the end of the day, it all comes down to temperament and tolerance for risk. Are you the type of person that likes to keep every nickel leveraged and are you willing to devote considerable time and energy chasing after the best return? Or would you
rather make one purchase and forget about it, content that your property might appreciate at its own rate? 

 

For a free consultation and analysis on your current or prospect properties please contact us immediately. You'll be surprised with the new outcome that may be available to you!