July 15th 2018
When I make an investment, I have a choice. I can use all my own money to make the purchase, or I can use some of my own money and borrow the balance. Whenever the purchase is supplemented with the use of borrowed funds, we say that we are leveraging the purchase. Very simply, leveraging is the practice of making money with the use of someone else’s money. Often the return on our investment can be increased greatly when we leverage the purchase. This is especially the case when it comes to investing in real estate.
We saw last month that real estate is one of the best investments we can make. This is because real estate offers not one but two opportunities for generating wealth. First, real estate is an appreciating asset. Over time its value will increase. But secondly, real estate will also generate an income stream all the time we own it. This income stream, of course, is the rent that tenants pay in exchange for the right to occupy the property. And it’s because of this income stream that leveraging makes so much sense in a real estate purchase. The rent or cash flow actually covers the full cost of borrowing and generates a surplus as well which we can use to pay back the loan. Let me give you a couple of simple examples to illustrate what I mean.
For the sake of illustrations, I’m going to presume the cost of the money we borrow is repaid in the form of simple interest. In actual fact, this isn’t the case. When we leverage a real estate investment, the borrowed funds (mortgage) is generally charged at a compound rate of interest and repaid in blended monthly payments. This actually works in our favour, because with every payment the amount we owe is slightly reduced. Plus the interest we must pay is correspondingly reduced somewhat every month. But, in order to simplify the math, we’ll base our calculations on simple interest and a non-decreasing balance. Also, forgive me if it seems we’re getting a little heavy into the math in this and our next couple of articles, but it’s your money and I want to help you make lots of it. To do this, you’ll need to understand and appreciate how the principle actually works.
Lets assume you have $200,000 to invest. (Don’t be intimidated by that amount. It’s just for illustration purposes. We could actually use any amount.) With the $200,000 you could go out and buy a $200,000 rental property. In today’s economy it’s fair to assume with a typical rental property you could expect a net return of at least 6%. This means on a $200,000 purchase, after expenses, you should end up with about $12,000 in your pocket. But now let’s apply the leveraging principle. Let’s suppose you put 20% of your own money down and mortgaged the balance. How will that affect your rate of return?
Mortgage rates today are running at about 3¾%. So, now in our leveraged scenario, you invest $40,000 of your own money on that $200,000 purchase and carry a mortgage of $160,000. The interest on that mortgage at 3¾% will be $6,000. This will leave you with a net income of $12,000 - $6,000 or $6,000. But remember, you only invested $40,000. So now your actual rate of return on the money invested (often referred to as ‘yield’, or ‘cash-on-cash return’) looks like this:
So, by leveraging your investment, you actually increased your effective rate of return from 6% to 15%. Now lets see what would have happened if you’d put only 10% or $20,000 of your own money down. In this case, the mortgage you would be carrying would be $180,000, which at 3¾% interest would generate interest charges of $6,750. This would leave you with a net income of $5,250. But let’s see what your actual rate of return would be now with only $20,000 of your own money invested.
Hopefully you’ve followed the math without too much difficulty. Take some time to go over it until you’re comfortable. It’s amazing what leveraging your investment can do to your rate of return. But this is only half the story. Don’t forget in addition to cash flow, real estate also creates wealth through capital appreciation. By leveraging our investment we also greatly magnify our return through capital appreciation as well, as we’ll see next issue.
Wayne Quirk, Author
“THE MONEY MACHINE”
wayneq@remax-gc.com