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Leverage in Real Estate

In the post “What is my investment property worth?” we looked at how cap rates reflect value. In this article I would like to explore with you the impact of leverage on that equation. That is, the use of other people’s money to enhance the rate of return on your money. As an example, say we look at a rental apartment building selling for $900,000 with a net income, after typical expenses (insurance, maintenance, heat, hydro, vacancy, management, etc.) of $54,000. This would represent a 6% rate of return if you purchased the property for cash.

As Per the Formula:

 

Now let’s consider the leverage we finance 80% of value i.e.: $720,000 on a first mortgage at 4%. For simplicity of the example, we will say that the repayment is interest only. That is $720,000 x 4% = $28,800 interest annually. Our net income after interest payment is now

 

Our Down Payment

 

Our Yield Leverage

 

Considerably better than 9%

The effectiveness of this tool is dictated by the spread between the rate of return when purchased with cash and the interest rate on the borrowed money. Also to a lesser degree by the amount of money borrowed in relations to the down payment; The greater the spread, the bigger impact. When you think that at 12% compounded, your money doubles every 7 years. It is obvious that in an environment of low interest rates, this tool can have a profound impact on your net worth in a shorter period of time! There again is another simple but powerful tool for increasing your investment returns.

Good Fortune

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