Real Estate Leverage: Use Other People's Money To Make More Money
When you compare real estate returns with other investment opportunities, it might not seem that impressive at first glance. You can get around 8% in annual returns if you invest in the S&P index passively so even if you compare that with more typical 4% annual appreciation plus 4% net rent yields on real estate, it’s really not that exciting … but that’s probably because you forgot to factor in the power of leverage! Real estate is the only asset class where you are able to get the most leverage possible and the lowest borrowing rates, and this allows you to multiply your success by four or five fold.
Now investing with leverage can significantly bump up your returns, but it is also higher risk. So in this video, I’m going to give you a better idea of how leverage works, how to use leverage safely, and finally tips on how to get the most out of leverage for real estate.
What Is Leverage?
Successful leverage allows you to use other people’s money to make more money, but it only makes sense if your expected returns are more than your borrowing cost. When you use less of your own money, you’ll in turn be more leveraged, and being so gives you a higher expected rate of return.
Here’s a quick example based on a $1M investment property that you can get in Toronto right now.
Let’s assume you pay for that property all in cash so if you make 8% of the property’s value per year, in five years time, compounded, you would be up $470,000. In other words, 5 year return on investment would be 47%.
Now try that again but this time instead we’ll only pay for 20% of the price in cash, and then pay the rest of the 80% using a mortgage which is typical of what our real estate investors are able to get. You still make 8%, minus 2% in interest, so in five years compounded with rough calculations, you’ll up $338,000. If you stack that against your $200,000 investment, your ROI in this case would be 169%.
I simplified things a bit here and didn’t factor in closing costs or repair costs, but hopefully you get the main point that I was trying to convey, which is that leverage can knock your returns out of the park, and when that happens, your returns will definitely be better than the S&P index.
200Bps Check: How To Use Leverage Safely
As you know, higher risk translates to higher reward. Being more leveraged naturally means that your investment will get more risky and so it’s just as important to use leverage correctly. We want to make sure we’re safe and that we can afford our monthly expenses and mortgage, so that we can actually hang on for the long term and reap those amazing returns after leverage. Of course you can crunch exact numbers on an excel spreadsheet, but if you want to do things on the fly, we have a quick, rough way to check that you’re safe and not cash flowing negative each month.
Cap rate > Interest Rate + 200bps
If you don’t know what cap rate is, I have a video that talks all about it. In a nutshell, it’s your net rent yield that you get by subtracting annual operating costs before your mortgage from your annual rents, and then dividing that by your property value.
And I’ll try to explain this formula a bit more. We’re trying to make sure we stay at least cash flow flat, so your net rents needs to cover your interest. Your principal paydown is represented by the 2% and we can fact check this by heading to a mortgage calculator.
- On a $1M property with a 20% downpayment, 30 year amortization and a 2% interest rate, the annual principal paydown is around $20K, so that’s 2% of $1M.
- If we change that to 1.6%, the principal paydown is just over $20K, still around 2%.
- Principal paydown gets lower with a higher interest rate, so at 3% interest, we’re looking at around a $17,000 principal paydown, so even at that point using 2% for principal paydown does provide enough buffer to make sure our cash flows are safe.
So remember this quick way if you want to check cash flows on the spot.
ROI Check: Does It Beat The S&P500 Index?
Sometimes, other people tell me they also want to check that their real estate investment after leverage does perform better than just investing in the index. I’d argue that it’s not really necessary. If you agree with me, just skip over to the next section that I have marked, but if you want to walk through my thought process with me, then keep following along.
Essentially, we are checking that your appreciation plus your cap rate minus your interest rate after leverage is more than 8%. We just did another check just before with cap rates and interest rates, so we can use a bit of algebra and to simplify this formula. When we plug in the first equation into the second, it gets simplified into this:
Appreciation > 8 / leverage – 2
As you can see, this formula got simplified because of the first check, and how cap rates and interest rates aren’t variables anymore and we’re just left with comparing appreciation with leverage to make sure we’re doing better than the S&P.
- At 5x leverage, annual appreciation just needs to be more than -0.4%.
- At 4x leverage, appreciation just needs to be over 0%
- Even at 2x leverage meaning we put in 50% cash and get a 50% loan, annual appreciation would just need to be more than 2% to bet the S&P index.
This is still a pretty low bar. Average annual inflation is already more than 2% and we would never advise you to invest in things that go down in value in the long run, and that’s why I think this check is really not necessary.
Instead of meeting the bar minimum, let’s flip the table and talk about opportunities where we can maximize our returns with leverage.
The first thing I’d recommend is to choose properties that have the best appreciation potential because this gives the bigger impact in my opinion. A 1% difference in annual appreciation might not seem like much, but in 10 years time that’s a 10% difference. Then after you factor in five times leverage, that’s actually a 50% difference in ROI.
Let’s compare that with if you invested in something else that had 1% lower appreciation but 10% higher rents which seems like a bit more. 10% higher rents actually just means a half percent better cap rate, or a 25% increase in ROI after leverage. In other words, the 1% higher appreciation opportunity is still the better investment.
Now let’s look at how the long term appreciation stacks up in Toronto vs. nearby areas:
- Toronto’s 10 year appreciation is 127%
- Vaughan’s at 116%
- Barrie’s at 105%
- Hamilton’s at 101%
- Oshawa is at 105%.
Choosing to invest in Toronto wins hands down from an appreciation standpoint.
Maintaining Consistent Leverage
Let’s talk about the second thing to be mindful of. As you make your monthly payments, you’re paying down your principal each month so over time, you’ll own more equity and have a smaller loan, and this also means that your leverage will shrink over time. So once you have a bigger percentage of equity and you want to maximize the power of leverage, it’s a good idea to refinance the property at market value so you can pull more cash out to reinvest. If you choose to go that route, we’d recommend going with variable mortgages because they offer more flexibility and lower penalties compared to fixed rate mortgages.
Increasing Your Returns Over Time
Your total return is based on the difference between your expected return and your cost of borrowing, magnified by leverage. What this means is that of course you’d want to have the maximize that difference at the start, but it will get even better if you can increase the difference over time which will continue to help you generate even better returns. So the best scenarios would be to buy when rents are on the rise, when property prices are expected to go up more quickly, combined with locking in lower interest rates.
At the moment in Toronto, we’re consistently seeing housing supply shortages combined with growing demand as immigration resumes so we expect stronger price growth ahead. On the rental front, Toronto rents have tanked over COVID, and now it’s rising quickly again so that’s another a good sign. Finally, there’s still uncertainty in the market keeping interest rates low. All of these factors point to it being a great time to enter the Toronto real estate market right now.
How We Can Help
We’re experts in investing in Toronto real estate and if you want help getting started, we’re the best team to fill that role! We will look at your requirements and preferences and then match you up with the best investment property that fits your needs.
After we help you buy it, we also provide renovations guidance, leasing and property management if you need it. Just connect with us if you want to learn more about our services!
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