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Leverage: Good or Bad?
When financing an investment property, “leverage” is defined as “the use of borrowed funds to acquire an investment.” Leverage can be used to increase cash flow, magnify the affects of appreciation and enhance the tax advantages of owning real estate. Leverage can also increase the risk or likelihood that an investor can lose equity, among other things.
The following simple example demonstrates the good and potential bad that can come from leverage.
Purchase Price (Value):
| $100,000
|
Debt (Borrowed Funds):
| $90,000
|
Equity (Down Payment):
| $10,000
|
Loan to Value (LTV):
| 90%
|
Cap Rate (unleveraged return on equity) is 10%
Cost of Borrowed funds (debt) is 7%
Cash Flow
Positive Cash Flow without/with Leverage:
(1) Investor pays all cash for the property (no leverage). Investor would earn $10,000 per year or 10% on their money.
(2) Investor puts $10,000 down and borrows the balance of $90,000 for interest only at 7%. The investor will still earn 10% ($10,000) but will need to pay $6300 in interest ($90,000 X 7%). The total return is $3,700 or 37% cash on cash return.
Negative Cash Flow with Leverage:
(3) Investor puts $10,000 down and borrows the balance of $90,000 for 7% interest amortized over 10 years. The investor will earn 10% ($10,000) and his annual payment for principal & interest is $12,804. The investor would need to pay $2,804 per year out-of-pocket to service the debt. The investor is increasing equity (paying down the debt via amortization) and enjoying other benefits of the investment but has a negative cash outlay of $233.66 per month ($2,804 divided by 12).
Appreciation: In examples 2 & 3, above, if the market value of the investment appreciated or increased to $110,000 (10%) the investor would have doubled their money ($10,000 equity plus the amount of appreciation). If the market went against the investor and the investment lost 10% of its value, the investor would have lost 100% of their equity.
Tax Advantage: By investing in a larger property with a larger dollar value assigned to the improvements the investor can increase the amount of depreciation they can deduct from their tax obligation.
In spite of major advantages in using leverage, the increased risk of loss should be examined. A decline in the market as seen above and the risk of interest rate fluctuation (initial loan interest rate is less than the refinance rate or market rate available when it is time to sell) can create a loss causing a negative impact on value.
When considering how much to leverage a property, the investor should consider if the lender has recourse against the borrower should they need to take back and sell the property. If the loan is a recourse loan (as apposed to a non recourse loan) the borrower could be required to make up any loss the lender might sustain on the sale of the property.
When considering an investment with leverage or debt, the quality of the tenants and the terms of the leases should be carefully compared to the terms on the debt. Long term credit tenants whose leases correspond to the terms on the debt provide more security to both the investor and the lender.
As a general rule of thumb, 60% to 65% loan to value is considered conservative leverage providing the investor with the advantages of leverage but not putting the investor excessively in harm’s way. By conservatively leveraging the property the investor will also receive the most favorable loan terms because of the reduced risk to the lender.
As always, a consultation with a tax professional that understands the investor’s specific tax situation is a must before moving forward on any investment.
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