Good Debt Vs. Bad Debt: When Does Leverage Make Sense For Real Estate Investments?
In this video, let’s talk about leverage. But instead of just explaining what it is, I’m going to focus on when I think leverage is a good idea for investment properties, and when it might too risky.
When you use leverage, you borrow money to boost the financial performance of something. What this means is if the market moves in the right direction, your returns can look a lot better with leverage. But same goes for losses. If the market moves in the wrong way, then you also magnify your losses so leverage can be dangerous when you don’t use it properly.
Leverage: An Example
Here’s an example. Let’s assume you can make stable 10% returns from a proven business. If you have $100, without leverage you make $10. But if you can borrow another $100 @ 2%, then with $200 you can make $20, and use some of that to pay the bank back $2 in interest. So leverage here amplifies your returns from $10 to $18.
But what if your returns aren’t stable and you end up losing 10%? If you put in your own cash at $100, you lose $10. If you borrow an extra $100, leveraging here makes you lose $20 plus another $2 in interest to your lender. So as you can see, leveraging investments with unpredictable returns can be very risky.
Applications Of Leverage
I haven’t talked about my past jobs before but one of them was in corporate and investment banking and that role really clarified the two sides of leveraging for me.
On one side, I saw corporates make good use of debt to increase their business income. But on the other side, I also saw speculative clients try to boost returns using financial derivatives. What happened here was they bet on on the swings in the market plus their positions were leveraged and this ultimately ruined a big handful of large corporates during the financial crisis in 2008 to 2009.
So after that, I went on to start my own business. I didn’t use leverage to open multiple locations on day 1 since there was no proof of concept and it would be way too risky. But once I tested things out and created a good model to follow, then it made sense to use leverage to grow my business to multiple locations. Now where I’m getting at is that this exact reasoning applies to leveraging investment properties. The rental portion of your investment property is a business with stable income so if you use leverage to boost your rental income, it can be a good idea.
But it’s not as simple as that – before you go ahead, it’s a good idea to check these three things to make sure it’s a great idea:
1. Your Rental Income Should Be More Than Outgoing Cash Flows
Your rental income should be more than how much you pay out on a monthly basis including operating expenses and your mortgage. Now we know that real estate goes up in the long run but if you need to make sure you can hang onto your property if market dips happen.
The reason I’m stressing on this is we know there are speculative condo investors ok are ok with no or negative cash flows because they are betting that condos will appreciate faster than houses. But the reality is that appreciation is not guaranteed so if something unpredictable happens like COVID, some of these speculative investors might lose their holding power and they may have to sell at a loss.
2. You Need A Loan That Won't Be Recalled Or Require Topups
You need a loan that won’t be called or require topups with small market movements. If you’re getting a traditional mortgage with a bank, the contract usually says that the bank will lend you a set amount for a fixed period of time as long as you make your monthly payments.
This isn’t the case with all loans and a good example of a riskier way to borrow money is from margin trading with stocks. When you trade on a margin and prices swing the wrong way, you’ll either need to top up with more cash or take a loss. So this type of loan is a lot more risky and reduces your holding power especially when the markets are moving against you.
3. Test Your Investment Property Under Extreme Conditions
You hear banks doing stress testing – now I encourage you to do some testing on your own just to make sure your investments are okay under more extreme cases. For example, how would your property do if vacancies increase?
Typically, vacancy rates in Toronto are at around 1% and with the pandemic with really is a good example of an extreme case, we’e seeing higher vacancies at 1.8% now. So instead of just using 1% as your vacancy rate, bump that number up and see how that would affect cash flows. Another thing you can test out is to see how much rents can drop before you turn cash flow negative. You can even test how much interest rates can go up before leveraging falls apart.
One easy way to stress test your property is to use our online calculators, where you can test out different scenarios by change up your variables like vacancy rates, rents, and interest rates. For example, for this sample property we have in our calculator, we’re at $1,000 cash flow positive at the end of each month based on a 1% vacancy rate. This cash flow number will drop when vacancies increase to 25% which is 3 months, so from this stress test you can see that this investment is pretty secure. If you want to head to our investment calculator, you can check it out here.
How We Can Help
A key takeaway is that not all properties are the same. When properties have positive cash flows, you’re more likely to weather a storm which make your investments more secure especially when combined with leverage.
Our team focuses on freehold income properties in Toronto and we know which ones make great investment opportunities. We don’t just help you buy the investment, we’re here to help you throughout your entire journey for questions and support you especially as the real estate environment changes. We’re happen to help you get started with real estate investing in Toronto when you’re ready.