14

The larger a mortgage I have on a property the less money I have to put up front so my initial cash flow is worse but my cap rate and overall return is better. However the larger my down payment the better my cash flow immediately because the required mortgage payments will be smaller, but my initial return will be smaller too, right?

I've heard that more leverage will always give a better return in the long run regardless of cash flow. Is this true? Are there instances where this isn't true?

17

There are two obvious cases in which your return is lower with a heavily leveraged investment.

  1. When the interest payments on the loan outweigh the return.

If a $100,000 investment of your own cash yields $1000 that's a 1% return. If you put in $50,000 of your own money and borrow $50,000 at 2%, you get a 0% return

  1. Whenever returns are negative

(After factoring in the interest as above.) If you buy an investment for $100,000 and it loses $1000, that's a -1% return. If you borrow $100,000 and buy two investments, and they both lose $1000, that's a -2% return.

  • 1
    This doesn't consider equity though. In the 2nd case you could purchase 2 properties instead of 1 and gain equity in both for "free". So if the equity return is greater than 1%, it would be a net gain. If there is no equity return, then it's a wash. – TTT Jun 9 '16 at 14:55
  • I'm considering general investments, and considering 'return' to be all returns, income and equity. – DJClayworth Jun 9 '16 at 14:56
  • Got it. So to make the math right we could assume the 2% loan is interest only, and the property never appreciates. In that case, I agree; the first option is infinitely better than the second option. – TTT Jun 9 '16 at 15:00
  • @TTT It's dangerous to consider property value appreciation as part of a real estate investment property, because it's something that can really vary substantially and can easily drop in value. Safer to consider the month to month return (cash flow) primarily. – Joe Jun 9 '16 at 16:09
  • @Joe - Agreed. But it does come into play if you're comparing purchasing 1 property outright vs 2 equal properties by financing 50% of each. Regarding appreciation, just like month to month return, you get double the risk or double the reward...(though it doesn't enter into the calculation until you sell). – TTT Jun 9 '16 at 18:15
10

Leverage means you can make more investments with the same amount of money. In the case of rental properties, it means you can own more properties and generate more rents. You exchange a higher cost of doing business (higher interest fees) and a higher risk of total failure, for a larger number of rents and thus higher potential earnings.

As with any investment advice, whenever someone tells you "Do X and you are guaranteed to make more money", unless you are a printer of money that is not entirely true.

In this case, taking more leverage exposes you to more risk, while giving you more potential gain. That risk is not only on the selling front; in fact, for most small property owners, the risk is primarily that you will have periods of time of higher expense or lower income. These can come in several ways:

  • Inability to find a tenant, or inability to find a tenant for sufficient rent to cover the mortgage. Having a higher mortgage payment and multiple properties can amplify this, although having multiple properties can also reduce the chance it will happen to all of them at once. If it does happen to all of them at once, it's very challenging to have sufficient reserves to survive several months of no rents if you're highly leveraged.
  • Unexpected repair costs for multiple properties. If you leverage yourself into three properties instead of two, for example, if all three have unexpected damage that is not fully covered by insurance, you may end up in a bad situation financially. This is not unlikely; you could easily have hail or flood damage on all at once, for example, that is not fully covered by insurance and costs you a significant amount (at least the deductible for each property).
  • Rental market shifts causing your rents to be lower. A higher mortgage (from higher borrowing costs and lower down payment) means your rents must be higher to cover that mortgage; if the rental industry takes a dive, or if you price into your model some expected increase that doesn't happen, you are at a higher risk of being unable to stay afloat. Even if you're still "making money" due to paying off principal of the mortgage, you may end up in a situation particularly early on where you're forced to sell one or more properties at a loss.

If you weather these and similar problems, then you will stand to make more money using higher leverage, assuming you make more money from each property than your additional interest costs. As long as you're making any money on your properties this is likely (as interest rates are very low right now), but making any money at all (above and beyond the sale value) may be challenging early on.

These sorts of risks are magnified for your first few years, until you've built up a significant reserve to keep your business afloat in downturns. And of course, any money in a reserve is money you're not leveraging for new property acquisition - the very same trade-off. And while you may be able to sell one or more properties if you did end up in a temporarily bad situation, you also may run into 2008 again and be unable to do so.

4

More leverage means more risk. There is more upside. There is also more downside.

If property prices and/or rents fall then your losses are amplified.

If you leverage at 90% then a 5% fall means you've lost half your money.

  • I only lose money if I sell, not if I hold. I'm asking about the return on the money put in and how it's affected by cash flow, not equity on the property. – LCIII Jun 9 '16 at 13:58
  • 1
    @LCIII If rents drop, or taxes or other expenses go up, you lose by holding. – Nathan L Jun 9 '16 at 14:10
  • 5
    @LCIII -- "I only lose money if I sell, not if I hold"? Who told you that? The loss is only realized when you sell, but the FMV of an asset is its FMV right now. If you buy a house for $100,000 and its FMV descends to $90,000, you have lost the $10,000, whether you sell it or not. Yes, the house could go back, but you could sell it and buy stock and that stock might go up instead. Don't get caught in the loss aversion trap. – Malvolio Jun 9 '16 at 19:02
2

I would say that you should keep in mind one simple idea. Leverage was the principal reason for the 2008 financial meltdown. For a great explanation on this, I would HIGHLY recommend Michael Lewis' book, "The Big Short," which does an excellent job in spelling out the case against being highly leveraged. As Dale M. pointed out, losses are greatly magnified by your degree of leverage.

That being said, there's nothing wrong with being highly leveraged as a short-term strategy, and I want to emphasize the "short-term" part. If, for instance, an opportunity arises where you aren't presently liquid enough to cover then you could use leverage to at least stay in the game until your cash situation improves enough to de-leverage the investment. This can be a common strategy in equities, where you simply substitute the term "leverage" for the term "margin". Margin positions can be scary, because a rapid downturn in the market can cause margin calls that you're unable to cover, and that's disastrous.

Interestingly, it was the 2008 financial crisis which lead to the undoing of Bernie Madoff. Many of his clients were highly leveraged in the markets, and when everything began to unravel, they turned to him to cash out what they thought they had with him to cover their margin calls, only to then discover there was no money. Not being able to meet the redemptions of his clients forced Madoff to come clean about his scheme, and the rest is history.

The banks themselves were over-leveraged, sometimes at a rate of 50-1, and any little hiccup in the payment stream from borrowers caused massive losses in the portfolios which were magnified by this leveraging. This is why you should view leverage with great caution. It is very, very tempting, but also fraught with extreme peril if you don't know what you're getting into or don't have the wherewithal to manage it if anything should go wrong.

In real estate, I could use the leverage of my present cash reserves to buy a bigger property with the intent of de-leveraging once something else I have on the market sells. But that's only a wise play if I am certain I can unwind the leveraged position reasonably soon.

Seriously, know what you're doing before you try anything like this! Too many people have been shipwrecked by not understanding the pitfalls of leverage, simply because they're too enamored by the profits they think they can make. Be careful, my friend.

1

leverage amplifies gains and losses, when returns are positive leverage makes them more positive, but when returns are negative leverage makes them more negative. since most investments have a positive return in "the long run", leverage is generally considered a good idea for long term illiquid investments like real estate. that said, to quote keynes: in the long run we are all dead.

in the case of real estate specifically, negative returns generally happen when house prices drop. assuming you have no intention of ever selling the properties, you can still end up with negative returns if rents fall, mortgage rates increase or tax rates rise (all of which tend to correlate with falling property values). also, if cash flow becomes negative, you may be forced to sell during a down market, thereby amplifying the loss.

besides loss scenarios, leverage can turn a small gain into a loss because leverage has a price (interest) that is subtracted from any amplified gains (and added to any amplified losses). to give a specific example: if you realize a 0.1% gain on x$ when unleveraged, you could end up with a 17% loss if leveraged 90% at 2% interest. (gains-interest)/investment=(0.001*x-0.02*0.9*x)/(x/10)=-0.017*10=-0.17=17% loss

one reason leveraged investments are popular (particularly with real estate), is that the investor can file bankruptcy to "erase" a large negative net worth. this means the down side of a leveraged investment is limited for the highly leveraged investor. this leads to a "get rich or start over" mentality common among the self-made millionaire (and failed entrepreneurs). unfortunately, this dynamic also leads to serious problems for the banking sector in the event of a large nation-wide devaluation of real estate prices.

1

QUICK ANSWER

When it comes to fixed income assets, whether rental real estate or government bonds, it's unusual for highly-leveraged assets to yield less than the same asset unleveraged or lowly-leveraged. This is especially so in countries where interest costs are tax deductible.

If we exclude capital losses (i.e. the property sells in future at a price less than it was purchased) or net rental income that doesn't keep up with maintenance, regulatory, taxation, inflation and / or other costs, there is one primary scenario where higher leverage results in lower yields compared to lower leverage, even if rental income keeps up with non-funding costs. This occurs when variable rate financing is used and rates substantially increase.

EXPLANATION

Borrowers and lenders in different countries have different mortgage rate customs. Some are more likely to have long-term fixed rates; some prefer variable rates; and others are a hybrid, i.e. fixed for a few years and then become variable.

If variable rates are used for a mortgage and the reference rates increase substantially, as they did in the US during the 1970s, the borrower can easily become "upside-down," i.e. owe more on the mortgage than the property is then worth, and have mortgage service costs that exceed the net rental income. Some of those costs aren't easy to pass along to renters, even when there are periodic lease renewals or base rent increases referencing inflation rates. Central banks set policies for what would be the lowest short-term rates in a country that has such a bank. Private sector rates are established broadly by supply and demand for credit and can thus diverge markedly from central bank rates.

Over time, the higher finance-carrying-cost-to-net-rental-income ratio should abate as (1) rental market prices change to reflect the costs and (2) the landlord can reinvest his net rental income at a higher rate. In the short-term though, this can result in the landlord having to "eat" the costs making his yield on his leveraged fixed income asset less than what he would have without leverage, even if the property was later sold at same price regardless of financing method.

==========

Interestingly, and on the flip side, this is one of the quirks in finance where an accounting liability can become, at least in part, an economic asset. If a landlord borrows at a high loan-to-value ratio for a fixed interest rate for the life of the mortgage and rates, variable and fixed, were to increase substantially, the difference between his original rate and the present rates accrues to him.

If he's able to sell the property with the loan attached (which is not uncommon for commercial, industrial and sometimes municipal real estate), the buyer will be assuming a liability with a lower carrying cost than his present alternatives and will hence pay a higher price for the property than if it were unleveraged.

With long-term rates in many economically advanced countries at historic lows, if a borrower today were to take a long-term fixed rate loan and rates shortly after increased substantially, he may have an instant profit in this scenario even if his property hasn't increased in value.

0

If you are calculating simple ROI, the answer is straightforward math.

See This Answer for some examples, but yes, with more leverage you will always see better ROI on a property IF you can maintain a positive cash flow.

The most complete answer is to factor in your total risk. That high ROI of a leveraged property is far more volatile and sensitive to any unexpected expenses. Additionally, a loss of equity in the property (or an upside-down mortgage) will further impact your long term position. To put this more simply (as noted in the comments below), your losses will be amplified.

You cannot say a leveraged property will always give you a better ROI because you cannot predict your losses.

  • 1
    It's generally a bad idea to highlight (i.e. quote) the result you don't want to say. – DJClayworth Jun 9 '16 at 14:39
  • You will NOT always see better ROI withn more leverage. If returns are negative, ROI is worse with more leverage. 2 times -1 equals -2. – DJClayworth Jun 9 '16 at 14:59
  • @DJClayworth, OK yes I can be more clear. Thanks. Edited. I thought I was clear enough by mentioning the volatility and risk, but you are correct. – jkuz Jun 9 '16 at 15:35
  • +1 for bringing up free cash flow. Free cash has an opportunity cost. +1 if I could for risk, you may not have to be underwater or behind to trigger a loan being called in, but you should be far away from both. R/E has a rougher margin call. – mckenzm Jun 10 '16 at 2:15

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