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.

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