Borrow more money or?
REAL ESTATE
Borrowing money can increase the return on your investment but be careful….
One of the biggest benefits (and in some case draw backs) associated with real estate as an investment is the high degree of financial leverage that’s potentially available.
Financial leverage can be defined as the use of fixed cost debt in an investment which is designed to increase the return to the owner of the investment.
By using mortgage financing it is possible to increase the rate of return on your investment. If you can borrow funds that have a fixed charge and funds which do not participate in the income or appreciation of the property, you can gamble that the investment will generate sufficient income to not only pay the operating expense associated with an investment but also make the payments on the debt.
If the investment does well, any income that is greater than the operating expenses and mortgage payments is allocated only to the equity investor and is not shared by the mortgage lenders.
Here’s a couple of examples…
Lets say you purchase a property for $200,000 and are able to finance the property with a mortgage rate having an interest rate of 8% and an amortization period of 30 years. Lets assume that the net operating income (amount of money left after operating expenses associated with the property but before your mortgage payment) is $30,000 per year. Lets also assume that you can borrow 30%, 60% or 90% of the $200,000 purchase price, also know as the loan-to-value ratio.
| Loan-to-value ratio | 30% | 60% | 90% |
| Net Operating Income | $30,000 | $30,000 | $30,000 |
| Less: Mortgage Payments | $5,283 | $10,566 | $15,849 |
| Before Tax Cash Flow | $24,717 | $19,434 | $14,151 |
| Equity Investment | $140,000 | $80,000 | $20,000 |
| Total Mortgage | $60,000 | $120,000 | $180,000 |
| Return on equity | 17.66% | 24.29% | 70.76% |
Mortgage payments = annual mortgage payments
Equity Investment = Purchase price – amount borrowed
Return on equity = Return on equity/Equity Investment
With a 30% loan to value ratio, the annual mortgage payments total $5,283. Subtracting the mortgage payments from the net operating income leaves $24,717. Based on your investment of $140,000, your return on your investment would be 17.66%. Take a look at how your return increases the more you borrow. WOW, a whopping 70.76% with a loan-to-value ratio of 90%.
Oh if only everything was this rosey…BUT…
Financial leverage can also work against you… 🙁
Let’s use the same example as above but assume that your net operating income has declined by say $15,000 per year to just $15,000
| Loan-to-value ratio | 30% | 60% | 90% |
| Net Operating Income | $15,000 | $15,000 | $15,000 |
| Less: Mortgage Payments | $5,283 | $10,566 | $15,849 |
| Before Tax Cash Flow | $9,717 | $4,434 | -$ 849 |
| Equity Investment | $140,000 | $80,000 | $20,000 |
| Total Mortgage | $60,000 | $120,000 | $180,000 |
| Return on equity | 6.94% | 5.54% | -4.25% |
With a 30% loan to value ratio, the annual mortgage payments total $5,283. Subtracting the mortgage payments from the net operating income leaves $9,717. Based on your investment of $140,000, your return on your investment declines to 6.95%. Now take a look at how your return on equity declines the more you borrow. With a loan-to-value ratio of 90% your return on equity declines to -4.25%, OUCH…
Another risk associated with financial leverage is the risk associated with rising interest rates. Interest rate can also impact rates of returns. Try your own example by calculating a mortgage payment with a higher interest rate and inputting into the calculations above. In all cases, the greater the interest rate associated with borrowing, the lower the rate of return.
When investing in real estate, it’s always a good idea to run this type of scenario to see your actual return on your investment. As with any investment “due diligence” is always of utmost importance.