In our first installment, we outlined the basics of refinancing a rental property. This week we will be talking about a variation of the refinancing concept – leveraging your investments to obtain more.
In academic terms, leverage means using various financial instruments or borrowed capital to increase the potential return of an investment. For us real estate investors, this means using debt, such as a mortgage, to obtain a property.
People often think that in order to take your investing to the next level, you need to work harder for your money. But it’s not that simple. The opposite is also true. Your money should be working harder for you, too.
I’ll illustrate the process using Bill. Hi Bill!
Bill is looking for an investment opportunity so he can retire early. He’s got his eye on a beautiful condo in the heart of the new Toronto Waterfront to purchase as an investment property. Let’s say the condo he’s looking at is selling for $300,000.
Now, there’s one problem. Bill is like many of us. He’s just an average guy. He doesn’t have $300,000 lying around in his bank account, waiting to be invested.
He does, however, have a house. And, unlike his brother Steve who rents, he now has $300,000 in equity he can use to invest.
Bill has two options. Option A: buy the condo outright. The upside to option A is that he won’t have to deal with mortgage payments. However, he will have depleted all of his capital on one property. And, all his equity is now in one basket.
Then, there’s option B.
Option B will see Bill put the required 20% down payment on three rental properties – or $100,000 down payment on three $500,000 condos. Why? There are a couple of benefits to using leverage in this way. Let me explain.
Imagine Bill buys the $300,000 condo. A year later, his investment has appreciated 4.1% (the average appreciationfor the GTA over the last year). That means a year later, his property has appreciated 4.1%, and is now worth $312,300. $12,300 extra? Not bad!
But that return could be even better. Your money can work harder than that!
If Bill went for option B and put down $100,000 on three nicer condos – worth $500,000 each – then he would see 4.1% appreciation on three different properties. That means the next year, each property is now worth $520,500. That means he has a return of $61,500! Now we’re talking!
Yes, the cash flow of option A is certainly better than B. But, with the second option Bill is able to obtain three assets instead of one. And, Bill is a buy and hold investor, and in 20 years he will be able to enjoy the cash flow from all three.
As time goes on, those three properties will also build equity, which will make acquiring further properties even easier.
“But Ryan,” you may say. “What about those of us that don’t have $300,000 of equity yet?”
Baby steps, my friend. If you have just enough for a down payment on one condo, it’s a great start. As you accumulate real estate, you will have all those assets which you can now leverage to invest in other endeavors. To start, Bill only had his home he could leverage, now he will have four properties he can play with.
However, like all forms of investing, we do need to be careful to not over extend ourselves.
But, don’t worry. We’ll cover risk minimization in the next installment in the Condo Investing Secrets series.
Ryan Coyle, CoFounder CONNECT Asset Management