Cash or debt? Weighing up the financing options for real estate investment

Those considering investing in real estate have many decisions to make, one of the most important being financing. How should an investment property be financed? Should you use your own savings or take out a loan? In this article, we compare cash purchases and debt financing in real estate investment, explain the concept of leverage, and consider the impact of interest rate markets on real estate investment. We also look at other aspects that can help you make the best possible decision.

Cash purchases: pros and cons

There are several advantages to buying with cash. First of all, it is risk-free. When you buy a home entirely with your own money, you don't have to worry about loan repayments or interest rate rises. This brings peace of mind and frees up time for other things. Secondly, a cash purchase can give you a better negotiating position in real estate transactions. The seller may agree to a lower price when the buyer is not dependent on a bank loan and the transaction can be completed immediately without a bank. 

However, cash purchases also have their drawbacks. The biggest one is that they tie up a lot of capital in a single investment. If all your savings are used to purchase a single apartment, you may not be able to afford to invest in other properties or take advantage of other investment opportunities. This can limit the diversification of your investment portfolio and increase risk. In addition, cash purchases mean you lose the opportunity to take advantage of leverage and the benefits it brings.

Cash buyers enjoy full cash flow, as they do not need to transfer part of their rental income to the bank to pay off their loan and interest. Now that the tax deduction for income-generating loans has been abolished, loans are no longer as beneficial for investments. 

Debt financing: leveraging the power of leverage

Debt financing, or taking out a loan, is the most common way to finance real estate purchases. Debt financing allows you to buy multiple properties and diversify your investments, which reduces risk. In addition, debt financing can multiply the return on your investment through leverage.

What is debt leverage?

Leverage means that borrowed money is used to increase the return on an investment. When a home is purchased with borrowed money, the investor's own capital is smaller, but the return on the investment may be higher. This is because the interest rate on the loan is usually lower than the return on the investment.

In Finland, real estate investors typically use 20% or 30% of their own funds to purchase a property. In some cases, investors may be able to get away with a smaller down payment.

An example of how leverage works:

Let's assume that you buy an apartment worth €100,000 with a rental yield of 6%. If you buy the apartment entirely with cash, you will receive €6,000 in rental income each year. If, on the other hand, you buy the apartment with 20% of your own capital and 80% with a loan at 3% interest, you will receive €6,000 in rental income each year and pay €2,400 in interest. The net return on your investment will then be €3,600, which is 18% of your invested equity (€20,000).

Risks of leverage

However, leverage also involves risks. If property values fall or rental income decreases, loan repayments and interest may eat into the return on your investment. It is therefore important to carefully assess your own risks and ability to service the loan before taking out a loan.

Impact of the interest rate market

Interest rates have a significant impact on debt-financed real estate investment. For example, a rapid rise in the 12-month Euribor rate can significantly reduce the profitability of an investment. This is particularly evident when an investor has several debt-financed properties.

Rising interest rates increase loan servicing costs, which may result in rental income no longer covering all expenses. This, in turn, may lead to cash flow problems and, in the worst case, even the sale of apartments at a loss.

Example of the impact of rising interest rates:

Let's continue with the example calculation used earlier, where you bought a €100,000 apartment with 20% of your own capital (€20,000) and 80% with a loan (€80,000). In the calculation, the original interest rate on the loan was 3%.

Let's assume that the interest rate on the loan rises by 2 percent, from 3% to 5%.

• New interest expense:€80,000 * 0.05 = €4,000 per year
• New net income:€6,000 (rental income) – €4,000 (interest expenses) = €2,000
• New return on equity:(€2,000 / €20,000) * 100% = 10%

In this example, a 2 percentage point increase in interest rates reduced the return on equity from 18% to 10%. This shows how an increase in interest rates can significantly reduce the return on a leveraged investment. If interest rates rose even further, interest expenses could even exceed rental income, turning the investment into a loss.

It is important to monitor developments in the interest rate market and prepare for interest rate rises, for example by taking out interest rate protection on a loan or choosing a fixed-rate loan.

Other factors affecting financing and its selection

• Investor age and investment horizon: Young investors typically have a longer investment horizon and greater risk tolerance, which makes debt financing an attractive option. Older investors, on the other hand, may need more stable and risk-free investments, in which case a cash purchase may be a better solution.
• Investment strategy: If the goal is quick returns and flipping apartments, leverage can be a useful tool. For long-term, stable investments, cash purchases may be a better option.
• Market situation: The situation in the housing market may influence your financing decision. When housing prices are falling, a cash purchase may be a more attractive option, whereas when prices are rising, debt financing may be preferable.
• Your financial situation: Before taking out a loan, it is important to assess your financial situation realistically. You must be able to service the loan even if interest rates rise or your rental income decreases.

Summary

Cash purchases and debt financing are both good options for financing real estate investments. Investors should keep in mind that there is actually a lot of leeway between debt leverage and cash purchases. For example, an investor can choose 80% or 30% debt leverage. It is useful to calculate the different options using sample calculations in order to find the solution that best suits your own situation.

Cash purchases are risk-free, but they tie up a lot of capital. Debt financing can multiply the return on investment through leverage, but it also involves risks, especially when interest rates rise. The best financing option depends on the investor's individual circumstances, risk tolerance, and investment objectives.