Using Leverage in Real Estate

In this new real estate market, the early bird gets the worm. Being well educated and knowing how to use leverage effectively will be a key part of any real estate investor's life. Everyone has his or her personal risk tolerance level, and this will play a major role on how much leverage to use. The investor must find a balance between reducing his or her down payment and reducing his or her positive cash flow. Positive cash flow is always the primary goal in any investment, that's why negative cash flow should be avoided because it will force you to find other areas to produce income to overcome the monthly deficit. It will also dramatically reduce your chances of obtaining another mortgage on future investments. Negative cash flow can also turn you from investor to speculator. Being a speculator is not the goal.

One of the goals when using leverage is to have a good return on investment (ROI). The higher the ROI, the higher the risk. Maximizing your ROI should not be your main focus, nor should reducing your down payment to nothing. The ultimate goal is to find the perfect balance between both. With the help of three different scenarios, I will give you examples on how this can apply to real property on a property purchased at $200,000 with net pre-tax income of $1,200 per month. Now using Ottawa's excellent appreciation rate of roughly 6.27% annually we can now calculate our unit's forecasted value by the time you sell in 5 years. Also will use a typical mortgage for this exercise of $160,000 at 5 years fixed at 5.49% over 25 years.

Scenario #1, Purchased with all cash

Sold five years after purchase

Purchase price: $200,000

Sale price: $271,071

Net pre-tax capital gain: $71,071

PLUS

Net pre-tax income(rent): $72,000

($1,200 x 60 months)

EQUALS

Net pre-tax capital gain: $71,071

Net pre-tax income(rent): $72,000

Pre-tax profit: $143,071

Overall (not annualized) ROI 72%

Scenario #2, Purchased with 20% cash down

Sold five years after purchase

Purchase price: $200,000

Sale price: $271,071

Net pre-tax capital gain: $71,071

Down payment: $40,000

(20% of $200,000)

PLUS

Net pre-tax income(rent)

($1,200 - $975 mortgage payment)

($225 x 60 months) $13,500

EQUALS

Net pre-tax capital gain: $71,071

Net pre-tax income(rent): $13,500

Pre-tax profit: $84,571

Overall (not annualized) ROI 211%

Scenario #3, Purchased with 20% down from Line of Credit

Sold five years after purchase

Purchase price: $200,000

Sale price: $271,071

Net pre-tax capital gain: $71,071

Down payment: $40,000

(20% of $200,000)

Down payment cost $6,400

(106.67$ LOC payments x 60 months)

PLUS

Net pre-tax income(rent)

($1,200 - $975 mortgage payment)

($225 - $106.67 x 60 months) $7,100

EQUALS

Net pre-tax capital gain: $71,071

Net pre-tax income(rent): $7,100

Pre-tax profit: $78,171

Overall (not annualized) ROI 1221%

As you can see there are many parts of this equations that can vary that can include:

-Cash available

-Source of down payment

-Net income after expenses

-Interest rates

-Potential sell price

-Overall cash flow goals

Each investor will be in a different situation, so there is no exact answer for everyone. Even if the properties do not increase in value as much as Ottawa's excellent appreciation rate predict they will, there is still the possibly of making a significant investment. Try it out for yourself.

In conclusion, using all of your capital to avoid a mortgage is not always an advantage and the best option so find the right option that works for you and that will bring you positive cash flow. Negative cash flow you will not let you have the financial freedom and you will have to find another source of income to make up for the losses. Real Estate investing is not a get rich quick scam, its a long term process that can bring wealth creation. It's best to treat it like a business and to deal with knowledgeable sales people who have the inside edge on investing.

Nick Labrosse