When it comes to investing, many people invest their assets in the stock market. But have you ever considered real estate instead? Unlike the stock market, real estate is a tangible asset that can generate two to three times more ROI.
So, you need to know about investing in rental properties, and be able to break into this competitive and profitable Toronto market?
One of the most essential factors to consider when venturing into rental real estate is leverage. Investing in real estate has become a common way to diversify your investment portfolio, it tends to carry these opportunities that investors could take advantage of to maximize their returns. Fortune in this investment is back to increasing net worth with leveraging.
What Is Leverage?
Leverage is the amount of debt an investor has in its mix of debt and equity, Capital Structure. Leverage is a technique used by both people and companies to expand the potential for returns, while it can also lead to losses if values decline. In real estate, the most common way to leverage your investment is with your own / partner money or through a mortgage, a mortgage is a straightforward example of leverage in real estate. Another case of leverage is where the property seller is willing to fund a portion of the buying price, Vendor Takes Back Mortgage (VTB).
Leverage in Real Estate
Consider the common real estate purchase requirement of a 20% down payment combined with good credit history. That’s $160,000 on a $800,000 property. By putting down only 20% of the money down and borrowing the rest, the buyer essentially uses a relatively small percentage of their own funds to make the purchase. The majority, therefore, is provided by a lender. In this case, investors will be using 80% leverage.
Rental Cap Rate
Let’s assume you had $800,000, and you invested all of it in a rental property. Right now, your rental income per month is $2200 after deducting all the expenses (i.e. property tax). In a year, you are making $26,400.
If we divide that annual net income by your initial investment, the return you get is 3.3%.
Comparing this gain to the gain from a purchase made outright, you had $160,000 but chose to go for leverage, considering you are making mortgage payments in addition to your expenses, your monthly net income is $520. Yearly, that would amount to $5040.
Dividing that figure by the initial investment ($160,000) gives us a cap rate of 3.9%.
Buyer’s Purchase Rate of Appreciation
Let’s assume the property appreciates at a rate of 5% per year. This means the borrower’s net worth grows to $840,000 in just 12 months. Comparing this gain to the gain from a purchase made outright, without any loan, highlights that value of the leveraging strategy. For example, the same borrower could have used the $160,000 to make a paid-in-full purchase of a $160,000 property.
Assuming the same 5% rate of appreciation, the buyer’s net worth from the purchase on an all-cash $160,000 property would increase $8,000 over the course of 12 months, versus $40,000 for the more expensive property. The $32,000 difference demonstrates the potential net worth increase provided through the use of leverage. Now, picture that 5% gain every year for 20 years.
Combined Cap Rate: Rental Income + Real Estate Wealth
If we divide that combined Annual net rental income & Appreciate rate by your {own money + mortgage investment ($800K)}, the return you get is
(45040 / 160000) x 100 = 28.5 % [Pay tax for; $5040 annual rental income – (mortgage interest to be paid)]
If we divide that combined Annual net rental income & Appreciate rate by your {own money ($800K)}, the return you get is
(66400 / 800000) x 100 = 8.3 % (Pay tax for; $26,400 annual rental income)
Considering both rental cap rate and property appreciation rate and also tax benefit factor, the use of leverage can have a very significant impact on your net worth, especially over time.
Furthermore, in cases where you spent all your excess cash into investment, you can purchase 4 more rental properties :{ 800K – 160K = 640K (4 x 160K, 20% down payment)}, if you can still get extra mortgages; 4 x 80% = 320% Leverage.
Assuming they are all making decent returns that would create more rental income and real estate wealth on your portfolio.
But the key points for the above mentioned profits are borrowing cost and property price, higher payments tend to carry more risks. You should avoid leveraging risks in rental investment by accounting for mortgage payments, vacancies, and a tough economy.
The bottom line, although you can use leverage to your advantage, there are a few key points you want to make sure you avoid to give you a better edge in the market. If you need more help figuring it out, we’ll be glad to help you at zoodpm.