Using Leverage to Build Equity in Investment Real Estate – July 2015

Leverage has always been a great tool to allow for more rapid growth of equity when owning investment real estate while being able to deduct the annual interest expense. Although buying power is increased with the use of leverage, each property purchase or mortgage refinance that utilizes a new loan should be carefully evaluated.

Every investor’s tolerance for risk is different. Knowing your monthly payment will not change using a fixed-rate mortgage can be a good thing when the property type could have uneven cash flows from time to time; however, if the loan-to-value ratio was maximized to provide for the highest internal rate of return from the real estate investment, the ability to cover a high monthly loan payment can be challenging during periods of lean cash flow.

Use of less leverage, or even no leverage, may be the safest investment strategy to cover market swings in cash flow, but will generate the lowest rate of return on equity.

Having some of the loans in your investment real estate portfolio highly-leveraged, but not all, may be one strategy to diversify risk. Positive cash flow generated from those investments that utilized less leverage can sometimes cover for periods of lower or even negative cash flow in the more highly-leveraged investment properties. A few examples to demonstrate this point are provided below:

Investment Real Estate Example – No Use of Leverage

Assumed Value of Investment Real Estate: $500,000
Assumed Annual Net Operating Income From Property: $45,000
Cash on Cash Before-Tax Annual Rate of Return: 9%

Investment Real Estate Example – Same Property but Use of 75% Leverage

Assumed Value of Investment Real Estate: $500,000
Assumed Equity: $125,000
Assumed Mortgage: $375,000
Assumed Annual Net Operating Income From Property: $45,000
Assumed Annualized Mortgage Payments: $29,575 (20-year amortization, 5% interest)
Before-Tax Cash Flow Remaining on Equity: $15,425
Before-Tax Annual Rate of Return on Equity: 12.34%, plus growth in equity from paying off mortgage over 20 years and deducting the mortgage interest expense

Investment Real Estate Example – Same Property but Use of 50% Leverage

Assumed Value of Investment Real Estate: $500,000
Assumed Equity: $250,000
Assumed Mortgage: $250,000
Assumed Annual Net Operating Income From Property: $45,000
Assumed Annualized Mortgage Payments: $19,717 (20-year amortization, 5% interest)
Before-Tax Cash Flow Remaining on Equity: $25,283
Before-Tax Annual Rate of Return on Equity: 10.11%, plus growth in equity from paying off mortgage over 20 years and deducting the mortgage interest expense

Another way to minimize risk is to use higher leverage for lower-risk property types, and lower leverage for higher-risk property types. Actual and perceived market fluctuations can affect the amount of risk associated with various property types; however, there are some characteristics that generally result in one property type being more risky than another. Hosch Appraisal & Consulting, Inc. can provide resources for evaluating and comparing different property types relative to client risk tolerance. Once an investment real estate portfolio is established, especially if leverage is utilized, it can be helpful to review the property types relative to the current and projected market conditions every few years to maintain a manageable level of risk while striving to achieve individual investment goals.

Leave a Reply

Your email address will not be published. Required fields are marked *