Friday, January 25, 2013

Rental Property Investing - Cautions in Leveraging

Based on our prior blogs on Leverage, the opportunity to increase returns is clearly a prudent strategy for many. But it should be applied on the right properties and primarily those with the right circumstances. A realistic understanding of the risk involved should be foremost in your decision making.                                                 

Let’s look at the following ‘Cautions’:
  1. Mortgage Payments Change When Interest Rates Rise – if the payment is manageable in the intial term (say 3 years), what happens if the rate rises 2-3% in a subsequent term. Does the return disappear? – Can the payment be covered?
  2. Maximum Leverage vs. Poor Real Estate – the best leverage deal does not improve a bad investment . You can also lose focus on value, lack opportunity for appreciation, and easily be ‘underwater’ at some later stage. Lucrative financing can often be a trap!
  3. Cash Flow is Key – Is the current cash flow sustainable? Are current rents in fact market rents?  Status of expiring leases?  All are key parts to this exercise.  Buy and Hold strategies very much depend on sustainable cash flows and lack of price appreciation is much less of an issue as a result. 
  4. Over Estimating Price Appreciation – being too optimistic in this area is a major downfall for many and results in negative returns. Best practice here is to be conservative and have this part of the risk analysis be of least importance – meaning future value appreciation, is not key to your decision in acquiring the property.
  5. Risks of Overleveraging with Personal Liability – the consequences can be catastrophic on a personal level if your portfolio of properties underperform and end up selling below the initial investment. Personal guarantees (known as convenants) are pretty common in the market today, so you need to understand the risks they present and factor that into your decision making.
A sound leverage strategy is worth implementing – but keeping the above points ‘top of mind’ as you execute your plan. As always, consult a experienced commercial realtor in your area, to assist in implementing your plan.

Thursday, January 17, 2013

Rental Property Investing - Increasing Returns by Financing

Expanding the discussion further on leverage, let’s examine what happens to the rate of return based on the annual financial performance of the property, after we factor in mortgage financing. In order for leverage to effectively work, the property must generate a good net operating income (NOI). This figure should be further analyzed to ensure its reliability (aka – accurate) and is consistent into the future (aka – stable leases). Refer back to our blog on “Confirming the Data”, if you need a refresher.

Back to our previous illustration:

          Property Purchase                  -$200,000
          N.O.I.                                     -$20,000
          Rate of Return                         -10%

          Cash Downpayment                -$60,000
           N.O.I.                                    -$20,000
        *Annual Financing Cost              -$11,964
           Rate of Return                        -13.3% ($11,964/60,000)
*Annual Financing Cost - $140,000 1st M @ 6% with Payments of $997/m (5 year fixed term/20 year amortization)

In low interest rate environments (as is the case across North America currently), leverage works best in cases where NOI’s are higher than the annual financing cost. Leverage can also be further enhanced if NOI’s are able to improve during a set time period (say 5 years), since the financing cost will remain fixed for the same period.  There are further tax benefits involved with financing a property because interest costs are tax deductible (more to come on that subject in a later post).

Conversely warning flags should be going up in the case of NOI’s which are below the annual financing costs or where NOI’s are expected to decline in the next 5 years.  But in the case of both scenarios, it gives us a good ‘base-line’ to evaluate properties, in examining their financial performance.  Lenders will usually only lend on a property based on NOI having a cushion over the annual financing cost - usually referred to as a "coverage ratio", something we will cover in a later post.

Again, it’s all local with real estate – and best practices, is to determine what sort of financing is available for properties you are considering. As always seek out experienced commercial realtors within your area, to assist you with your Leverage strategy.

Thursday, January 10, 2013

Rental Property Investing - Leverage

A few posts back, we touched on the concept of “Leverage” and now let’s expand the conversation. By definition, it’s simply using borrowed money to increase your return (aka profits) in an investment property. It is a legitimate investment strategy, but is best applied to ‘good cash flow’ properties, which would appear to have a probable likelihood of future appreciation.

Consider the following investment, as a simple illustration:

Property Purchase --  $200,000 (all cash investment)
            Recent/Projected  Market Growth – 5% per year
            After Year 2 -- $220,000
            ROI – 10% (on cash invested)

            Purchase Price   --  $200,000
            Cash Investment --  $60,000
            Recent/Projected Market Growth – 5% per year
            After Year 2   --  $220,000
            ROI – 33% (on cash invested)

This is a simplistic illustration and assumes the property is in a growth market,
which expects price appreciation – in this case 5% per year. It would not
be a realized gain, unless the property was infact sold after year 2.  But you can see based on the market assumptions which are made, the potential to increase your return goes up significantly in the second scenario.

In the case of a flat market (no growth), the return would be the same (0) - but you would have $140,000 to put towards other properties. For the record in a declining market, the negative return would be less in the first scenario - but you would also have more cash at risk ($200,000 vs. $60,000).

This gets the conversation started on Leverage, with more to follow when we consider the annual financial performance of the property.  Again, seek out experienced commercial realtors within your market to assist you in implementing a successful Leverage Strategy.