Becoming a new landlord is scary.  Even for existing landlords, expanding your rental portfolio can be a nerve-wracking endeavor.  How do you know you’re choosing the right property?  How do you know you’re going to make money at it?  How do you know you’re not biting off more than you can chew?  The last thing you want is to buy an investment property and then end up sliding backward into foreclosure.  You can lose your down payment, screw up your credit, and hobble your finances for years or decades afterward.  So how can you be sure that you’re going to be successful with your rental property?  The biggest key lies in the amount of a down payment you make.

How We Bought Our Building in La Habra with Virtually No Down Payment

Back in 2003, my family was looking into buying an apartment building.  My grandfather was strongly encouraging it, and if you knew my grandfather, you’d know that if he’s pushing for an idea, it’s almost certain to happen.

My grandfather was a lifelong investor, and no stranger to risk.  He made a lot of smart decisions in his lifetime, and accomplished some really great things.  He became an engineer, bought several mobilehome parks, went to law school (graduated, but didn’t pass the bar), helped his kids get launched financially, and later, his grandkids and even great-grandkids.

But he was also a risk-taker.  I don’t know exactly where he drew the line on whether a certain move was too risky, but I know that he was a lot more comfortable with risk than I am.  He was an airplane pilot, and loved flying all over the world in his little private plane.  He had so many stories about his flying misadventures.  There was the time when he flew into a storm (that he had been warned about, but he chose to fly anyway) and stalled out, and nearly ended up crashing with several of his adult children (including my mother) in the plane with him.  Fortunately, he overcame his panic and nosed the plane toward the ground, recovering enough speed to pull out of it.  He had a number of “unexpected landings,” as he called them, which anyone else would describe as “oh my God I can’t believe we’re on the ground and we lived through that.”

So in 2003, when my grandfather decided that we should buy an apartment building, he wasn’t the least bit concerned about a trivial things like a decent-sized down payment.  He figured that as long as we got our foot in the door, and could keep it afloat for just a few years, we could save enough money by managing it ourselves that we’d be making money in no time.  I wasn’t so convinced.

Back then, the banks were lending at a maximum loan to value ratio of about 70%.  We really didn’t have much set aside at all, so my grandfather concocted a way for us to get the other 30%.  He borrowed against one of the family mobile home parks, and had that business turn around and loan us the money at the same interest rate, as a pass-through.  This meant that we could buy a building for zero down, apart from coming up with the closing costs.

Why Going In With No Down Payment Is A Bad Idea

There’s a reason the banks require that investors come in with a decent down payment when buying a property.  Actually, there are a couple of reasons.  The first is that the bank wants to make sure you’ve got some skin in the game.  If property values dip by 10% after you buy the property, and if you’ve financed 100% of the value of the property, then you might be tempted to walk away from the loan and the property, and leave the bank holding the bag.

The other big reason the banks require a hefty down payment is because it’s impossible to make money on an investment property if you’re not making a good size down payment.  The smaller the down payment you make, the bigger your mortgage is going to be.  If you end up borrowing all of the money needed to buy the property, the loan payments are generally too big to be covered by the rents after paying all of the expenses.

Think of it this way: if everyone could buy investment property with basically no down payment, and if the investment would immediately generate enough cash flow to cover the huge mortgage payments, then literally everybody who had good enough credit would be buying those investment properties with no money down.  If all of those people with good credit suddenly became potential buyers, the market would be flooded with buyers, which would drive the prices of the property up.  The price of properties would have to rise to balance out the supply and demand.  That rise in prices would make the loan payments even higher.

But the rent amounts wouldn’t automatically increase to cover the cost of the higher mortgage.  Why not?  Because a flood of buyers looking to purchase investment property wouldn’t have any impact on the market rate of rents.  The market forces that affect rents are the renters’ income and the scarcity/availability of rental units.  More buyers flooding into the investment property market wouldn’t positively affect either of those criteria.  In fact, if buyers were flooding into investment properties with zero money down, it might even cause more vacancies in rental units, as newbie landlords moved out of their own rented apartments and into their newly purchased buildings.  That might actually increase vacancy rates and drive rents down slightly, making it even harder for landlords to pay their mortgages.

How We Fared Without a Down Payment

The previous two paragraphs are basically what I argued to my Mom when I was telling her that I thought buying a building with no down payment was a huge mistake.  Her counter-argument was this:

  • the building will increase in value slightly every year, keeping pace with inflation (or better)
  • the rents will go up slowly over time
  • the mortgage payments will stay the same

By her estimation, within about 5 years, we should have been earning positive cash flow.  Mom earns good money from her job and her other investments, so she figured she could cover the cash flow shortage for the first 5 years or so, until it starting trickling in cash on its own.

Well, here’s what really happened.  We bought the building in 2003.  Over the course of the next five years or so, nearly every wall oven and countertop stove (yes, they were separate) broke, and we had to replace them all.  Pro tip: if we had this to do all over again, I would have voted to replace the separate components with one stove/oven/range.  They’re way cheaper and more reliable than the separate components.  We also replaced all the angle stops, most of the faucets, and had a ton of plumbing issues.

So our maintenance costs were high between 2003 and 2008, our target 5-year mark for positive cash flow.  In addition, rents were mostly flat, or even starting to fall.  Between 2003 and about 2006, there were more and more vacancies, in large part because subprime lending was putting all of the people who should have remained renters into their own homes instead.  By 2008, when the economy hit the skids, it got even worse.  You would think all of the people getting foreclosed out of their houses would have moved back into apartments, but they didn’t.  First, lots of those homes continued to be occupied by the defaulted borrowers, because the banks had so much bad inventory on their hands that they couldn’t repossess it all at once.  So those guys didn’t need rental apartments.  Second, for those who did get foreclosed out of their homes, most of them were still drowning in debt from the second mortgages and HELOCs that they had taken out, and their credit was toast.  Those people moved in with family members or friends, and didn’t need rental housing.

So vacancies remained high, the economy was in the tank, and we were definitely not making any money by 2008.  In the years following, the economy slowly started coming back, and by about 2010, people finally started filling up the vacancies again, and rents started climbing slowly.  Interest rates went lower, and we were able to refinance in late 2011 to drop our mortgage payments.

2012 was our first year of positive cash flow, and the primary reason it went positive is because of the drop in our mortgage interest rate.  Our annual mortgage payments dropped from $207,000 per year to $143,000 per year.  Even after that drop, we were only cash flow positive by about $15,000.  Also, our expenses were very low at that time.

So 2012 and 2013 were cash flow positive, FINALLY.  Hooray!  2014 was negative again, for a few reasons.  One is that our resident manager at the time was being lax about taking rent payments on time, and stopped charging a late fee.  So some people fell pretty far behind on rent, and a couple eventually skipped out without getting caught up.  Two is because our maintenance costs were higher that year, including repaving the parking lot (around $35,000).

In 2015, when the loan modification went into effect, our mortgage payment dropped a little further, which helped a little, and the rents were raised fairly significantly to bring them up to market, since the rent raises that were supposed to happen in 2014 never got done (we needed to fire the resident manager). But our expenses, especially in the latter half of the year, were pretty high because we were preparing the building for sale.  There were some paint costs, some deck resurfacing costs, some more stoves/ovens that needed to be replaced, and an air conditioner that needed to be repaired.  All of the little things sent us back into the red again for the year.

So, recap: from 2003 to 2015, we were cash flow negative in 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2014, and 2015.  We were cash flow positive in 2012 and 2013.  So two out of 13 years were cash flow positive, and they didn’t start happening until year 10.  Yikes!

Fortunately, Mom was okay with injecting money into the company to keep us afloat all of those years.  Also fortunately, when the rents went sky high and the interest rates went very low, the property values went through the roof.  Our building that we bought for $2.675 million in 2003 sold in early 2016 for a whopping $5.2 million.  That was enough to cover the negative cash flow for all of those years, and then some.

So our experiment worked out in the end, but our situation was very unusual, and it made all of us very anxious in the first 10 years.  I don’t recommend it. If you have the cash flow to throw at a property if things go poorly, and if you think rental property prices are going to skyrocket during the next 10-15 years, then maybe it would be worth it to go all in and buy a building with basically zero down payment, although you will need to be creative about your financing to make it happen.  I wouldn’t expect another property value skyrocket like we’ve seen in the coming years, though.  As it is, the down payments required to get in and make cash flow right away are really high, and if you get cap rates that drop much below 5, you start having a lot of investors who would rather put their money in the stock market instead of buying and managing rentals.

Let me just clarify briefly that the point of this post is not to say I was right and Mom was wrong.  The point is just to say that sometimes things don’t work out quite like you expect, so if you need to be a little more cautious to make sure things don’t blow up in your face, then do it.  You may be hit with a huge recession like we were, and it may take years to climb out of it.  Or interest rates may increase, instead of decreasing like ours did.  The more leveraged you are, the more an interest rate increase puts your entire investment in jeopardy.

At the end of the day, Mom and I were both partially right.  I was right that we weren’t going to make money for far longer than the first 5 years, and she was right that it was all going to turn out just fine in the end.  But as for myself, I wouldn’t go into another property with no down payment again.  It’s just too risky for me.  For my new fourplex, I went in with about a 40% down payment, which is a little conservative, but I’m okay with that.  I want it to start with a positive cash flow right off the bat, so I can use it to try to pay the mortgage down faster, and eventually get another property.

What do you think is a good down payment percentage to shoot for?  What’s the lowest down payment you’ve ever made?