Smart Investment Moves: Identifying Profitable Properties for Leverage in Toronto Real Estate
Introduction
You’ve probably heard the statistic before: 90% of millionaires in the U.S. have invested in real estate. One key reason for this success is leverage—using other people’s money to make more money. When used properly, leverage can significantly accelerate wealth growth.
However, it’s important to note that leverage can work against you as well. Even when your returns are positive, investing with leverage may yield less than investing with cash, especially in a high borrowing rate environment.
In this video, I will discuss the types of properties that can perform better with leverage, enabling you to make informed decisions and be selective when investing in Toronto real estate amidst higher borrowing rates.
Let’s begin.
How Leverage Improves Returns
Understanding how leverage works is crucial. When you invest in something that generates better returns than your borrowing cost, you benefit from the power of leverage.
Let’s apply this concept to typical investments in Toronto real estate.
In 2020, a typical Toronto rental property had a net rent yield of 3.5% (cap rate). If you purchase this property with cash, your return on investment is 3.5%.
However, if you borrow 80% of the property’s value at a 2% interest rate, you can achieve a net rent of 1.5% on the purchase price while investing only 20% of your own money.
This results in a much higher return on investment of 9.5%, making it a favourable use of leverage.
How Leverage Worsens Returns
Nevertheless, leverage doesn’t always work in your favor.
If your borrowing cost exceeds the potential earnings from the property, such as when condo cap rates are 3.5% but borrowing rates are 5.5%, you’ll end up losing money when leveraging to invest in a condo.
Even when your borrowing cost is lower than the cap rate, leveraging may still result in lower returns. For instance, a typical house today may have a 4.9% cap rate.
With cash, you earn 4.9% return, but with leverage, your real rate of return may only be 0.5%. In both cases, leveraging increases risk, making it sensible only when returns surpass those from investing with cash.
Cap Rate For Leverage Effectiveness
To determine the cap rate that yields better returns with leverage, a simple rule applies: the cap rate must be higher than your nominal mortgage rate.
Keep in mind that the actual cost of borrowing is typically lower than the nominal mortgage rate, as you borrow less than the property’s value.
Factoring In Appreciation
While real estate appreciation can be a compelling factor favoring leverage, it’s prudent to assume appreciation will align with inflation. Consequently, appreciation cancels out when calculating real returns.
If appreciation surpasses inflation, leverage would enhance your rate of return when compared to investing with cash.
Toronto Real Estate Investing - A Effective Example
Given current mortgage rates around 6%, the objective is to find real estate investments with cap rates exceeding that threshold. Opportunities meeting this criterion exist in Toronto, typically involving multiplex properties and value-add work.
Here’s an example of a deal that we helped a client buy recently. The purchase price was $1,000,000 and needs around $100,000 in renovations. Once renovations are done, this property ends up generating an amazing cap rate of 6.5%.
With cash, your rate of return is 6.5%. With leverage based on a 20% downpayment, you end up getting 8.5%. So here, leverage does make sense. You end up improving rent yields with borrowed money and it’s a safe leverage choice because you’re getting great positive cash flows too.
How We Can Help
Our real estate sales brokerage specializes in identifying such properties for our clients. If you need assistance with real estate investing where leveraging makes sense, reach out to our team.
Take the first step by booking a discovery call with us!
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