Understanding the fundamentals of finance known as the time value of money is key in real estate investment. Such causes as inflation make the real value of a dollar less in the future than it is worth now. Because of this principle, buying property outright in cash does have its drawbacks, financially speaking, because another use of that cash may actually benefit the investor in the future more than it would if it was expended in an immediate purchase.

 When an investment is made using funds that have been borrowed, we call this activity leveraging. It is the expressed intent of the investor to make a return on the investment. If a $100,000 property were to appreciate 10% over a 12-month period, its value would be $110,000. The return on investment (ROI) would correspond to its appreciation of 10%, not including the costs of selling the property.

For those investments made with borrowed money, the resulting ROI is actually a much higher percentage of the out-of-pocket investment. Should the investor contribute $10,000 in the purchase of a $100,000 property, and capitalize the remaining $90,000 in financed funds, a 10% increase in the value would still yield an increased equity of $10,000. However, the ROI is 100%, because of its basis on the actual out-of-pocket investment of $10,000 made by the investor. Essentially, the investor doubled his investment! Of course, in financing the remaining $90,000, costs associated with financing interest would diminish the actual yield. As a way of allaying these financing costs, a good strategy would be to rent the property to generate revenue.

Let's broaden the scope of our example to a much larger undertaking. Instead of one property valued at $100,000 with 90% capitalization, let's target 10 properties at $100,000 with the same financing and down-payment ratios of 90/10. The same scenario of renting these properties for the life of the loans would yield a substantial ROI over the 20 years typical of these financing terms. Of course, before making such a vast investment with potential for great return and great loss, a wise investor would have to conduct due diligence in measuring this potential against such expenses as repairs, vacancies, and taxes.

On a similar note, the size of your down payment will affect your cash flow on rental properties. Let's consider two examples:

Scenario 1: Purchase of $100,000 property with $80,000 loan at 6% interest rate, including taxes and insurance, equates to a monthly payment of roughly $600 per month. Assuming you could rent the property for $800 a month, you have $200 monthly cash flow or $2,400 annually.

Scenario 2: Purchase of $100,000 fully financed with 8% interest rate (rates are generally higher for zero-down loans) amounts to a $900 monthly payment. Assuming a rental income of $800 again, you have $100 monthly NEGATIVE cash flow.

Of these scenarios, which would you prefer for your portfolio? This question begs the consideration of personal financial goals and standing.

If your plan in making these investments was to hold the property for 10 years, the Scenario 1would net you $200 monthly revenue, but your cash reserve would have been $20,000 less than when you started, which could cause problems for those with shakier financial footings. On the other hand, Scenario 2would be generating negative cash flow of $100 per month, but you would have the flexibility of your cash reserve being $20,000 the stronger. Most investors would opt for Scenario 1, but thinking critically may or not deem it the best option. Let's take a closer look at it.

When speaking about investment properties, unpredictable vacancies are always lurking. In the event that you chose Scenario 1 and the property remained vacant for one month, the overall monthly loss would be $600 ($800 foregone rent - $200 monthly appreciation= $600). Assuming the property was then occupied after only one month of vacancy, it would take the next three months of rent to make up the $600 loss and get back to square one($200 cash flow*3 months=$600). If Scenario 2 were the route taken, leaving the $20,000 down payment in the bank instead of towards the investment, the $1200 annual loss would be within a manageable range of loss, considering you would have that cash reserve as a cushion. In the event the property was in a highly lucrative area, the appreciation would more than make up for the $100 negative cash flow, assuming the property was never vacant.

The financing terms could also impact your decision in choosing an investment strategy. Zero-down loans with interest-only repayment plans are an option that can work with short-term investment strategies. For instance, if the loan had a fixed rate of 5% for the first three years of the loan, then a lease/option within 36 months would be a good exit strategy, yielding a profit and relieving you of costly interest after the expiration of the fixed rate term.

Ultimately, the lesson to take from this example is that fixed-rate loans may not always be the most profitable terms in securing leverage. Likewise, short-term positive cash flow should merely be an option, not a goal. Furthermore, zero-down plans and negative cash flows can be coupled with other strategies to turn a profit, contrary to intuition.

The societal consensus is that debt, empirically, is a bad financial feature to maintain. That is how most people are indoctrinated from childhood. "Free and clear" is the objective of many investors, no debt being the defining factor. Being debt free has many overriding positive aspects, but sometimes it is not the wisest financial move.

To further this point, the liquidity of property investments is limited. Should an investor manage free-and-clear properties, cash flow will be sustained, but should this investor need a large infusion of cash into his greater portfolio, the options would be limited due to the static nature of the value. One of the only options would be to sell the property. This, of course, would then entail loss of profit to taxes and selling expenses.

Refinancing the debt would accomplish the goal of a large capital infusion while also keeping control of the asset and avoid tax implications. Also, any interest could be written off come tax time. Even if the mortgage payment on a refinanced amount is large, it can all be deducted on your tax preparations, making the tax windfall more advantageous. This goes to show that positive cash flow, while desirable, is not the only way to be profitable. Growing equity is the optimal objective, which does not always coincide with positive cash flow.

Debt reduction is a good objective if better prospects are not readily seen in the market. Also, debt reduction could have other positive effects like allowing the investor to rid themselves of private mortgage insurance and additional savings on expenses.