Veteran real estate investors often talk about the power of leverage in the context of real estate. Leverage is one of the greatest advantages of real estate investing; it is what causes your real estate investment to accomplish potentially phenomenal returns. If you are new to the world of real estate investments and thinking of entering into this space, or have already developed a small real estate portfolio, leverage gives you the ability to use borrowed capital, as a basis of funding for your additional real estate investments. In the context of real estate, higher amounts of leverage is possible because the asset providing collateral for the lender is secure. While leveraging puts the borrower in debt and responsible for interest payments, it allows the investor to acquire more real estate than if they acquired the property with their own cash. This typically translates into a greater cash on cash return on your investment.
For example, an investor purchases a building for $1,000,000 debt free. Five years down the road, they sell it for $2,000,000. In this case, they have generated a cash on cash return of 100% ($1,000,000/$1,000,000). However, if this same investor borrowed $500,000 for this $1,000,000 property and used only $500,000 of their own cash, their cash on cash return on this same purchase becomes 200% ($1,000,000/$500,000) or double! As you can see, the higher the leverage, the higher the return. Furthermore, this same investor could have used his other $500,000 to invest in another property and generate higher gains by holding two investments. It should be stated that interest payments on debt for a real estate investment is generally 100% tax deductible.
However, just as leverage can work to one’s benefit, it can also work against an investor. For example, if one borrows $500,000 to acquire a $1,000,000 property and values fall, leverage works in reverse. If the property value falls to $800,000, a leveraged investment has a greater percentage equity loss than if it was purchased without debt. Similarly, declining values could potentially have the investor owing more money against the property, than its current market value.
While leveraging a property often works to one’s benefit, investors must be cognizant of a few key items to consider when utilizing leverage in the real estate context. Here are the Zeifmans Real Estate team’s key considerations to pay attention to when leveraging a real estate investment:
- Expecting an unreasonable level of property appreciation: Just because a property has had high levels of appreciation in the past or you have had success with other properties, look at each property individually. Do your due diligence. When leveraging real estate investments review a minimum of these three possibilities: best case; worst case; and most likely. A key focus for real estate investors needs to be a focus on covering cash flows. Simply relying on price appreciation is often not enough and doing so can have disastrous impacts to an investor in down turn cycle.
- Interest rate fluctuation: If one locks into a 5 year fixed-rate mortgage, consider your position in 5 years. If the interest rates increase, will you be able to cover your debt payments at that time? One should run a sensitivity analysis to ensure they can withstand a potential increase in interest rate. Given the current rising interest rate environment, this consideration is having a far greater impact then it has been over the past number of years. Consideration can be given to employing advanced financing strategies, including derivative based strategies, to reduce exposure to rising rates in the current environment.
- Terms of the loan: When the loan is structured, consideration should be given to the ability to exit the loan, if warranted, repay the loan and/or draw down higher amounts of leverage against the collateral. Borrowers can be stuck in a harsh loan and unable to exit if a better opportunity arises.
- Underestimating the importance of cash flow: One must realize their debt payments continue whether or not there have been vacancies. If reduced rent is being collected for periods of time, and debt is outstanding, the investor must ensure they have other sources of cash to cover the debt payments. Similarly, an investor needs to ensure that if operating expenses increase, they can still cover their debt payments.
- Interest deductibility: Under the Canadian Income Tax Act, interest payments in connection to the financing of a rental property or real estate investment is generally tax deductible as long as there is a reasonable expectation of profit. Consideration should be given to ensuring that the maximum amount of interest is deductible and in certain investment structures to ensure that the debt is held in a manner (possibly in a different entity than the real estate) where the interest is not limited or as beneficial as it can be as a result of other constraints such as capital cost allowance. It is also important to be able to trace the interest expense to the investment in order to ensure deductibility.
- How much leverage: In different situations lenders will be willing to lend a different amount of the loan to value (“LTV”) of the property. In some instances, such as multi residential apartments, it is generally safer to employ a greater amount of leverage and in other cases, such construction financing, it can be much riskier to employ higher amount of leverage. It is important to always ensure that, even if a lender is willing to provide a higher LTV, a borrower does not over extend themselves, which can potentially lead to issues with respect to repayment.
- Fees: When employing leverage in the real estate investment context a number of lenders charge various fees in addition to the interest charges. Novice investors who are used to residential mortgages on their homes can often be caught by surprise. The various fees can be significant and cannot be overlooked. Such fees need to be taken into consideration when preparing cash flow projections to ensure sufficient capital is available.