Passive Cash Flow for Buy & Hold Investing – Rentals vs. Seller Financing
- Jeff Groudan
- Mar 19, 2024
- 4 min read
In the world of real estate investing, generating passive income is a key goal for many investors. Rental properties are by far the most common and popular strategy. However, seller financing is also a popular alternative, especially with the recent increases in interest rates. Each approach will deliver consistent and relatively passive income. Each approach has its distinct advantages and drawbacks.
Rental Properties:
The main advantage of renting rather than selling with owner financing is the landlord’s ability to continue to benefit from the appreciation of the home over time as well as the tax deductions for depreciation, property taxes and mortgage interest. Renting is a well understood method for turning a property you own into an income generating asset.
However, being a landlord is not for everyone! Managing a rental property with tenants does require some management time. Landlords are still responsible for maintenance, repairs and capital improvements to the property. Also, depending on the location of the rental and demand for rentals, there can be periods of vacancy which can detract from a landlord’s expected profits. If you talk to a landlord, they will generally say that managing tenant issues is the hardest part of owning a rental property. No landlord wants to get a call on the weekend, or when they are out at dinner, and have to manage some kind of maintenance emergency.
Rental Properties Pros & Cons:
Pros:
Consistent Income Stream: Rental properties can provide a regular, monthly income from tenants. This is particularly appealing for investors seeking steady cash flow.
Appreciation Benefits: Over time, the value of the property may increase, offering investors capital gains in addition to rental income.
Depreciation: You can deduct depreciation from your annual rental income when you report your taxes. This will reduce your ultimate tax burden on the annual net income from rentals
Principal Paydown: Each year you hold the property, part of the principal owed on your mortgage is paid down using the tenant’s rent payments. This will steadily increases your equity.
Tax Advantages: Investors can deduct property-related expenses, such as maintenance, improvements, and interest on mortgages, potentially reducing their taxable income.
Cons:
Management Challenges: Rental properties require active management, including dealing with tenants, maintenance issues, and vacancies, which can be time-consuming and stressful.
Upfront and Ongoing Costs: The initial purchase requires a significant capital investment, and ongoing expenses like repairs, taxes, and insurance can erode profits.
Seller Financing:
Selling a property with seller financing is a different way of generating income from a real estate asset WITHOUT the headaches of being a landlord. The big difference is that instead of being a landlord, the seller becomes the lender instead.
If you have ever had a mortgage before, you know that the bank who lent you the money to buy your property fades into the background once the property is sold. They collect a monthly mortgage payment and, if you are paying into an escrow account, they pay your property taxes and insurance premiums once a year. Other than that, they have nothing to do with the maintenance of the home. So, with Seller Financing, once the property is sold, the seller transitions into the role of the lender. For the most part, the seller (now the lender) just collects the mortgage check each month. The payments (excluding property taxes and insurance) are generally fixed and do not change regardless of market interest rates, repairs or maintenance.
The new owner (the buyer) is responsible for repairs, maintenance, insurance, property taxes etc. The new owner gets any value from increased appreciation and principal paydown, but they are also responsible for increases in property taxes, insurance, roof replacements and any other necessary home repairs.
If you don’t want to tie-up your capital, you generally want to do owner financing with properties that have a mortgage already and you want to try to keep that mortgage in place. This can be accomplished by purchasing properties in the traditional manor and then reselling the property with owner financing OR buying properties “subject-to” the existing mortgage and then reselling. “Subject-to” purchases is an advanced strategy that entails purchasing properties without paying off the existing loan. You would take-over the payments and then resell the property with a 2nd mortgage, known as a wrap mortgage, to a new owner.
Owner-Financed Properties Pros & Cons:
Pros:
Stable Income with Interest: By acting as the bank, investors receive monthly payments that include interest, potentially offering a higher return than traditional rentals.
Reduced Management Hassles: Since the buyer is responsible for the property maintenance, insurance and taxes, the investor avoids the headaches associated with direct property management.
Cons:
Default Risk: If the buyer defaults on payments, the investor may need to go through the foreclosure process to reclaim the property, which can be costly and time-consuming.
Liquidity: The investor's capital can be tied up in the property for the duration of the financing agreement, which can be several years, reducing liquidity, unless you execute a wrap mortgage.
Due-on-Sale Clause: If you execute a wrap mortgage, to preserve your liquidity, it means keeping an underlying mortgage in place even though the name on the mortgage will no longer match the name of the owner on the lease. The "due on sale" clause is a allows the lender to demand full repayment of the loan if the property is sold or transferred without the lender's consent. While this rarely happens in practice, it is the risk of utilizing subject-to purchases and wrap mortgages.
In summary, while both rentals and owner financing offer profitable and scalable paths to passive income but come with different characteristics and different pros and cons. The choice between rental and owner-financed properties depends on a number of factors including an investor's financial goals, risk tolerance, and willingness to manage property-related issues.
Interested in learning more about Seller Financing?
Check out my book and online training on this topic!
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