Leverage is Everything

Doing the Math

With interest rates up (slightly) and cap rates fairly low, why would investors keep buying properties? The answer, or a very big part of it, is in the magic of leveraging. It’s something that should always be at the forefront of your mind when considering the returns you’ll earn on an investment in real estate. Here’s why.

When purchasing a home to live in, buyers have the added incentives of “paying rent to themselves” as opposed to their landlord and growing their wealth tax-free through property appreciation. In Canada, the government doesn’t tax us on the wealth we accumulate in our principal residence. This is kind of a huge deal. The government needs to collect taxes, and people need to pay them. But there’s also a bit of a game here, isn’t there? As part of their attempt to minimize taxes, every Canadian needs to be trying to earn and maintain their wealth, as much as possible, in tax-free savings vehicles, and primary residences are one such vehicle. This isn’t tax evasion and it isn’t tax avoidance. It’s financial planning. So owning your principal residence tends to make a lot of sense from a personal finances perspective.

But how does it look for the investor who is not purchasing a primary residence? They will pay capital gains tax on that wealth accumulated through property appreciation. Worse still, the income they earn collecting rent is also taxed, and not as capital gains, but as regular income. Capital gains are taxed at half of a person’s marginal tax rate.

How does one then calculate the returns on a property investment? What kind of return would qualify as a “good” return?

There are a number of ways to answer both of those questions. Here’s one possibility with a real-world example.

I personally would like to earn a 10% return on all of my investments. If I do better, great. But if I can get 10% compounding over a few decades, I figure I should be pretty comfortable in my later years. (Note that $50K compounded annually over 25 years, with no additional contribution, will leave you with over half a million smackers!)

Now the problem: how do I do that? The stock market is one option. I love my TFSA (open one immediately if you haven’t already). Still, diversification is important, and there’s something appealing about an investment that’s tangible, know what I mean?

What about an investment property? How do those numbers look in Greater Vancouver right now? Let’s look at an actual example.

The Subject Property

I’ve chosen 205-553 Foster avenue in Coquitlam to examine. This is R2287864, in case you are working with a different agent and want them to look it up afterwards. Listed by David Pan of Sutton Premier Realty. I don’t know David, but I suspect he won’t mind this extra advertising.

This is a 2-bedroom, 889SF, with parking, 5 years old, rentals allowed, by Burquitlam SkyTrain. Rentals in the area for 2-beds seem to be averaging about $2,000/month.

The sellers are asking $629K as of this posting. This is Foster by Mosaic, pictured below. The $/SF seems attractive, given the most recent sales in the complex.

Now, let’s do some math. I’ll assume I can get the unit for $625K and I’m able to secure a mortgage with 20% down. That’s $125K I need up front. Plus $10,500 for the property transfer tax. Plus another $1,000 for my conveyance.

Now, I’m hoping that even in this lending environment I can get a 3.5% mortgage rate. That means my payments on the $500K mortgage are going to be about $2,371.06. That’s a lot! Does this investment make any sense?

Number Crunching

Often property investors will refer to a “cap rate,” meaning capitalization rate, to evaluate a property. This is simply the net income divided by the purchase price. In this case, assuming average rent ($2,000) and subtracting my strata fee ($263.45 x 12), my property taxes ($2,335.50), insurance ($600), and factoring a 5% vacancy rate (not true, but we might as well be conservative), I’m left with $16,703.10 net. That’s a 2.7% cap rate. Ugh! I’m nowhere near my goal of 10% returns.

But is this the right way to do my calculations? Maybe, if you’re just comparing respective cap rates. (Even in that case, be careful! Some people will calculate cap rates using gross income as opposed to net income, for example. Be sure you are comparing apples to apples.) What I’m most concerned with, is how much of a return am I actually getting on the money I put down?

In this case, that amount is $136,500. How much I “make” with that downpayment is not necessarily an easy thing to determine, but let’s try. First of all, alarmingly, I’m not even covering my mortgage payments with the rent I’m getting. This one must be a loser, right? Not so fast. Someone is still paying me money, and that’s something. Leveraging is already working it’s magic in fact. My name may be on title, but I don’t really own this property if I only paid for 20% of it. The lender effectively owns 80%. But I’m entitled to 100% of the rental proceeds. That’s a pretty special arrangement.

Still, I’m going to have to throw an extra $979.13(!) at this thing every month (mortgage payments + costs – rental income). That’s $11,749.62 for the year. This isn’t how property investment is supposed to work! I’m supposed to be making money!!! What’s the story?

Equity

Well, I may throw in an extra $12K over that first year, but I am 1/25 of the way to clearing my $500K mortgage. Let’s say that represents $20K in equity. Truth is, you pay a lot more in interest (as opposed to principal) on your mortgage in early years, but I think it’s actually more insightful to view this as annually paying off 1/25 of the full mortgage.

So $20K in equity minus the $12K paid in is like an $8K gain. So now my initial $136,500 has allowed me to make an $8K gain. That’s about 5.8% return. Well, that’s a bit of a relief. Also, it’s nice to know that I can write off the mortgage interest (almost $15K in year one in our scenario) against the rental income, so there are hardly any taxes to pay (about $3K taxed at my marginal tax rate).

Leverage

Now here’s the kicker. If I hold this property long enough, property values will rise. Not every year, but they will rise on average over a given number of years. How much? The historical rate of return for homes in Canada is over 5%.

Now if my investment property gives me returns of 5% in capital appreciation, on top of my equity gains funded mainly by rental income, I’m in the zone!

But I’m still missing something. If a $625K investment increases in value by 5% ($31,250), but I’ve only paid $150K for that property, then I’ve effectively earned over 20% returns, just from that average property appreciation. And that’s the magic of leveraging. I only paid for 20% of the property, but I get 100% of the capital appreciation. This is why many investors buy rental properties and it’s why they actually like being leveraged and try to stay leveraged. Rather than paying off a mortgage, which is psychologically satisfying, they keep re-borrowing any principal that has been repaid to make another investment.

Variables

Please do keep in mind that we could play with all of the variables used in the example above and get different results. Some people will be able to get a mortgage rate below 3.5%. Interest rates change. Rents are likely to keep rising. Sometimes property values do stagnate (or drop). It’s good to keep a little extra on the side at all times for unforeseen costs.