By Nick Duarte.
If you’re like most people, buying property will be the largest purchase you’ll make in your lifetime. But if you strive to be the type of successful investor whose real estate portfolio produces generational wealth, you’ll have to understand which financing options are available to you and how to effectively utilize leverage to meet your investment goals. This article will provide insight into how you can use other people’s money to build your rental portfolio quicker than using your own cash while also maximizing expected yields.
Time To Purchase
Let’s consider a simple scenario: Two people, Anthony and James, with annual incomes of $65,000 each as well as $55,000 in savings, intend to invest in residential real estate property to generate rental income. They are both targeting similar properties priced at $80,000 in the same neighborhood. Neither one wants to do much rehab work, so the condition of the properties will also be similar.
James believes cash is king and will pay for his purchase using only his available funds and no other financing. Unfortunately for James, even with $55,000 on hand, that rental property is out of reach until he can save an additional $25,000.
Anthony, on the other hand, aims to utilize leverage to finance his investment properties. Working with a local agent and mortgage broker, he identifies two properties and is able to put down payments of $20,000 on two single family rental homes. Anthony begins to collect rent while James continues to dream and pinch pennies. It’s easy to see how using borrowed money allows investors to scale their rental portfolio at a faster rate than those paying all cash.
Cash Flow Consequences
Now, let’s consider expected returns if Anthony and James were able to purchase similar properties producing equal net operating incomes (NOI).
|Cash Purchase||75% Leverage|
|Less: Loan amount||0||$60,000|
|Less: Annual debt service||n/a||$3,750|
|Pre-tax cash flow||$6,000||$2,250|
*Adapted from ‘Investment Analysis for Real Estate Decisions’ by Phillip Kolbe, 8ed.
Looking strictly at cash flow amounts, it would seem cash purchases are the better option since the total return is greater. But let’s dig further into these numbers using a common metric known as cash-on-cash returns, which compares the amount of cash flow relative to the amount of cash invested.
Utilizing leverage, Anthony would have $20,000 invested in the property and can expect pre-tax cash flow of $2,250, an 11.25% yield. Meanwhile, James expects pre-tax cash flow of $6,000. However, with an initial outlay of $80,000, his 7.50% yield is two-thirds of Anthony’s. What does this mean? Anthony invested one-quarter the amount James did but realized higher yields.
Rate Of Return On Sale
It’s now five years later and Anthony and James are ready to sell their properties. Let’s assume their properties appreciated 5% annually and are now worth $102,100. As with the cash-on-cash returns, while the total proceeds from a cash purchase is higher, the rate of return using leverage is much more favorable.
|Cash Purchase||75% Leverage|
|Proceeds from sale after year 5||$102,100||$102,100|
|Less: balance due on loan||0||$55,097|
|Net sales proceeds (pre-tax)||$102,100||$47,003|
|Initial cash invested||$80,000||$20,000|
|Annualized rate of return||5.00%||18.64%|
Risk of Financial Leverage
With all the positive aspects of leverage, there are certain risks that investors must also understand. In the unfortunate situation of a string of vacancies or non-paying tenants, for example, operating income could fall below the annual debt service. If this were to happen, the owner would have a negative yielding property on their hands. On a similar note, if property values depreciate dramatically, a potential sale may not be able to pay off the loan balance.
Why Leverage Makes Sense
All things being equal, employing smart leverage supports an investor’s ability to purchase higher priced properties than they would otherwise be able to afford, as well as realize cash flow benefits and higher rates of return upon sale. If you would like to continue the conversation on how to best put leverage to use, contact CoreVest.
Our creative financing options have helped thousands of different investors fix and flip or buy and hold more than 25,000 investment properties and close nearly $4 billion in loans. Are you looking to explore your financing options? CoreVest is the leading lender to residential real estate investors. We provide attractive long-term debt products for stabilized rental portfolios as well as credit lines for new acquisitions. For more information about how CoreVest can help you grow your rental and rehab business, please call Nick Duarte at 949.523.3465 or email firstname.lastname@example.org