Rental property course · Lesson 2 of 6
A loan helps only when the property earns more than the loan costs.
Most rentals are bought with a loan. The loan changes the cash flow, the return and the risk. This lesson shows how to see all three before you buy.
The loan
Example House is bought with 25% down and a 30-year fixed loan of $225,000 at 7.0%. The payment is $1,497 a month, or $17,963 a year.
| Cash at the purchase | $ |
|---|---|
| Down payment | 75,000 |
| Settlement costs | 6,000 |
| Cash invested | 81,000 |
Cash flow in year 1
| Year 1 | $ |
|---|---|
| Net operating income | 17,371 |
| Mortgage payments | (17,963) |
| Cash flow before tax | (592) |
The payment is larger than the NOI, so Example House loses $592 of cash in year 1. The cash-on-cash return is that cash flow divided by the cash invested: -0.73%.
The coverage ratio divides NOI by the loan payments. For Example House it is 0.97. A ratio below 1 means that the rent does not pay the loan. The owner must add cash, or wait for the rent to grow. At a rent of $2,456 a month, year 1 cash flow is zero.
The loan constant
The loan constant is the yearly payment divided by the loan: 7.98%. It is higher than the rate, because the payment also repays principal.
Compare it with the cap rate. Example House earns 5.79% in cash on its price, and each borrowed dollar costs 7.98% in cash. So in year 1, each borrowed dollar lowers the cash return.
When leverage helps
Cash is only part of the return. The value of the house grows too. Over ten years, with 3% growth in value each year, the return is as follows.
| Example House, 10 years | Return a year |
|---|---|
| All cash, before tax | 8.03% |
| With the loan, before tax | 9.98% |
| With the loan, after tax | 8.93% |
With no loan, the house returns 8.03% a year before tax. That is more than the 7% rate, so the loan raises the return to 9.98%. If the house earns less than the rate, the loan lowers the return. Lesson 6 shows what happens when the value grows more slowly.
Key points
- Cash-on-cash return is the yearly cash flow divided by the cash invested.
- A coverage ratio below 1 means that the owner adds cash each month.
- A loan raises the return only when the property earns more than the loan costs.