As the credit markets continue their roller coaster, with guidelines and rates changing daily, it makes me wonder, "What does the future hold for real estate investors and their ability to secure funds to continue investing?" For people like me whose livelihood depends on real estate in the Birmingham area, seems to be a question that needs to be answered! Thinking about these things, brought me to the risks versus rewards when using debt to buy houses. Most people understand that debt allows for the possibility of higher returns (all other things being equal). But is that ALWAYS true? Let me give you an example out of our Golden Key Marketing Piece that I think is really helpful:
Let's use basic assumptions with our operating expenses . . . taxes, insurance, projected maintenance, management, and a vacancy/credit allowance. All this is assumed for us and lumped into one number. On the leveraged return, lets assume we can secure debt that meets the following criteria . . . 20 year amortizing loan, 7.5% interest rate, 20% down payment.
To make this a simple example, lets just work from the Year 1 return (we are going to examine only the returns for the first year we own the assets.) Using the "Ten House Package" example from our marketing piece, our "Projected Net Operating Income (NOI)" is $41, 934. NOI is calculated by subtracting "Potential Rental Income" less the above "Operating Expenses" Once we have NOI, we can use some simple math to find out our unleveraged return (this is also commonly referred to as "cap rate.") In our marketing piece the sales price for the particular package we are discussing is $400,000. If we take the NOI and divide it by the sales price, this gives us our projected return without leverage. In this example, the return is 10.48%.
Let's use basic assumptions with our operating expenses . . . taxes, insurance, projected maintenance, management, and a vacancy/credit allowance. All this is assumed for us and lumped into one number. On the leveraged return, lets assume we can secure debt that meets the following criteria . . . 20 year amortizing loan, 7.5% interest rate, 20% down payment.
To make this a simple example, lets just work from the Year 1 return (we are going to examine only the returns for the first year we own the assets.) Using the "Ten House Package" example from our marketing piece, our "Projected Net Operating Income (NOI)" is $41, 934. NOI is calculated by subtracting "Potential Rental Income" less the above "Operating Expenses" Once we have NOI, we can use some simple math to find out our unleveraged return (this is also commonly referred to as "cap rate.") In our marketing piece the sales price for the particular package we are discussing is $400,000. If we take the NOI and divide it by the sales price, this gives us our projected return without leverage. In this example, the return is 10.48%.
Example #1 - Unleveraged:
$41,934 / $400,000 = 10.48%
For a leveraged return, we take the above assumptions for the debt and apply it to the package (i.e 20% down payment = $80,000). To get a projected return using debt (also can be called "Cash + Principal on Cash Return") you take the cash flow (cash left over after all operating expenses and mortgage notes have been paid) which is $10,999. You then add this to the total amount of debt you pay down $7,178 (do not include interest, just principal) and divide it by the total cash invested, which is $80,000. If you do all this, you get a projected return of 22.72%, obviously much higher than the unleveraged example.
Example #2 - Leveraged:
($10,999 + $7,178) / $80,000 = 22.72%
While it may appear that leveraged real estate is ALWAYS the way to go, let me point out that this isn't entirely true. What happens if, instead of a 7.5% interest rate, the best we can find is a 15% interest rate? Let's keep all the other assumptions the same and look at the projections again:
The unleveraged investor will not see any change in his/her returns. It is pretty obvious that if you use NO debt and the price to borrow money changes, it doesn't affect you!
$41,934 / $400,000 = 10.48%
For a leveraged return, we take the above assumptions for the debt and apply it to the package (i.e 20% down payment = $80,000). To get a projected return using debt (also can be called "Cash + Principal on Cash Return") you take the cash flow (cash left over after all operating expenses and mortgage notes have been paid) which is $10,999. You then add this to the total amount of debt you pay down $7,178 (do not include interest, just principal) and divide it by the total cash invested, which is $80,000. If you do all this, you get a projected return of 22.72%, obviously much higher than the unleveraged example.
Example #2 - Leveraged:
($10,999 + $7,178) / $80,000 = 22.72%
While it may appear that leveraged real estate is ALWAYS the way to go, let me point out that this isn't entirely true. What happens if, instead of a 7.5% interest rate, the best we can find is a 15% interest rate? Let's keep all the other assumptions the same and look at the projections again:
The unleveraged investor will not see any change in his/her returns. It is pretty obvious that if you use NO debt and the price to borrow money changes, it doesn't affect you!
Example #1 - Unleveraged (@ 15% interest):
$41,934 / $400,000 = 10.48%
As for the leveraged investor, the new projected cash flow decreases to -$8,631. That takes our projection from +22.72% in the above example to a whopping -7.35%. You actually lose money every year. You can make more money sitting at home watching Days of our Lives.
As for the leveraged investor, the new projected cash flow decreases to -$8,631. That takes our projection from +22.72% in the above example to a whopping -7.35%. You actually lose money every year. You can make more money sitting at home watching Days of our Lives.
Example #2 - Leveraged (@ 15% interest):
(-8,631+ $2,748) / $80,000 = -7.35%
As you can see, leveraged real estate isn't always better. New investors commonly assume that leverage ALWAYS equals higher returns. That is why it is important to understand the risks and rewards when evaluating an investment on the front end . . . BEFORE you purchase it. Also understand that debt can fluctuate while you own the house (depending on you loan) and you must be prepared for these fluctuations.
If you'd like to discuss the matter further, post a comment. If you would like one of our marketing pieces that discusses purchasing investment houses in Birmingham, Alabama, email me at matthew@gkhouses.com.
Have a great day!
As you can see, leveraged real estate isn't always better. New investors commonly assume that leverage ALWAYS equals higher returns. That is why it is important to understand the risks and rewards when evaluating an investment on the front end . . . BEFORE you purchase it. Also understand that debt can fluctuate while you own the house (depending on you loan) and you must be prepared for these fluctuations.
If you'd like to discuss the matter further, post a comment. If you would like one of our marketing pieces that discusses purchasing investment houses in Birmingham, Alabama, email me at matthew@gkhouses.com.
Have a great day!
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