Is it better to have Cash Flow or hold a Cash Reserve?
When buying property, at some point you need to determine how much “cash” or “equity” you are going to put in and how much you are going to borrow. There are a number of considerations and each has their own good or bad consequences. Let’s have a look at one scenario which you might find thought provoking. Note that we will keep it very basic and disregard some influencing factors, just so as not to over complicate the point at hand.
Our investor is going to buy a property valued at $250,000 and has $50,000 in cash savings available to put into the deal. Estimated weekly rental return is a 5.8% yield = $1,208 per month
Option 1: $250,000 property with $50,000 down (80%LVR)
We’ll assume an interest only loan at 6.8% – a $200,000 loan @ 6.8% interest = $1,134 per month. With a monthly rental of $1208 the monthly cash flow after the loan repayment is $1,208 minus $1,134 = $74 per month positive cash flow.
Cash Reserves = ZERO
Option 2: $250,000 with $25,000 down (90% LVR)
As the LVR is higher, we’ll make the interest rate on the loan higher by 0.5%. Therefore we have a $225,000 loan @ 7.3% = $1,369 per month. With the same monthly rental of $1,208 the monthly cash flow after the loan repayment is $1,208 minus $1,369 =$161 per month negative cash flow. Also it would be typical that lenders mortgage insurance would have to be paid, let’s estimate this at $2,600. This will leave a Cash Reserve = $22,400.
Which option is less risky?
Which option makes better sense?
I guess that depends on your investment strategy, what your goals are and what your
overall financial situation is like.
Let’s say you plan to hold the property for say 7 years (hopefully it doubles in value by then). With the first option you have a $74 per month positive cash flow, but no cash reserve. In the second option, you have $161 per month negative cash flow, but you have $22,400 in reserve. Which option do you think is the safer one?
Here’s one way to look at it ……
In Option 1, if your rental property becomes vacant for one month, you would be out of pocket $1208. Where would you get this from? It would take 16.3 months (at $74 per month) to make that up.
In Option 2, you have a $22,400 cash cushion to make up the shortfall. With $22,400 in the bank, you could handle the $161 x 12 = $1,932 per year negative cash flow for 11.6 years. Or alternatively you could sustain 18.5 months of vacancy.
Interesting isn’t it. Of course there are many other aspects to consider like opportunity costs, equity refinancing, tax, interest of funds, etc, etc.
I’ve generalised in order to illustrate the principle and to get you to think about risk…..is 80% LVR safer than 90% LVR (with cash reserve)?
There’s no right or wrong way, but I suggest if your property experiences an appreciating market, you would come out just fine, even with the negative cash flow option.
Let us know if you have any thoughts on this and any other items…….we always welcome your feedback.
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Property Friends is a specialist Property Investment Strategist that provides solutions for people aspiring to financial independence, choices in retirement, or leaving a legacy. www.propertyfriends.com.au (03) 9758 5331