Leverage. Is it time to re-think your strategy?

Leverage, defined by Investopedia as an investment strategy of using borrowed money — specifically, the use of various financial instruments or borrowed capital — to increase the potential return of an investment, is a core strategy of real estate investors.
In my post entitled Real Estate Yield. Understanding Your Cash-on-Cash Return , I reminded readers that the amount of debt placed on a property was a crucial determinate of yield. While your strategy will be informed by your personal motivations as an investor, there has been a general acceptance that there is an efficient way to use debt. In recent years, maximizing debt has been a surefire method to increasing your cash-on-cash returns. In fact, the greater proportion of low rate leverage placed on an asset, the greater the cash-on-cash return. This is known as positive leverage.

Rising Rates. What’s the implication?
Rising rates result in higher carrying costs. The implications are obvious. A reduction in cash flow to an investor results. But what has this to do with leverage, or more specifically, the amount of leverage you employ? The best way to illustrate this, is with an example.

Let’s assume an investor purchased a $3,800,000 asset a year ago when rates were lower. The property generated $230,000 of annual cash flow before debt service, and he/she decided to finance with a short term (1 year) mortgage at 3.50%, amortized over 25 years:

As can be seen, the investor’s return increased as more debt was used. Let’s fast forward to today. Rates in our example have increased to 5.00%, approximately the yield today on Government of Canada 5 year bonds, plus 260 basis points, a fairly common spread presently quoted by institutional lenders:

In the second example, rates impact investor yield significantly, and the result is negative leverage. Each additional dollar of debt decreases the Cash-on-Cash return.

There are of course many considerations for an investor financing a property. Specific asset hold strategies, equity funds available, overall portfolio strategy, tax considerations, and others. However one would be wise to consider the implications of negative leverage. Importantly, it should serve to underscore the importance of the relationship between interest rates and property values. Property values will need to adjust downwards to compensate for higher interest rates. Your takeaway? Buy right, and secure the appropriate (for you) level of debt on your income property. Happy investing!

– by Allan Jensen