Beware the overuse of Leverage with rental properties.
Leverage! Used properly, leverage can be a very powerful tool for property managers and investors! If abused, or even slightly misused, it can become the downfall of even the mightiest real estate moguls!
Leverage is what makes real estate investing so appealing. I can’t think of another business where you can leverage a small amount of money, and turn it into a large net worth over time.
Why use leverage in real estate?
The idea here is that you can purchase real estate with as little as 5 or 10% of your own money, and borrow the rest in the form of a mortgage. As an example, say you purchase a $300,000 house with only 10% down, or $30,000. If that property appreciates 10% over a two year period (5% per year which is reasonable in certain markets), the value of the property is now $330,000, and you have doubled your money in only two years. That’s a 50% cash on cash return per year. I can’t think of too many stocks that perform quite like that…
The dangers of leverage in real estate!
Now that’s all well and good, but leverage can also work against you in certain instances. At the end of the day, it’s really all about cash flow. Without positive cash flow, the debt servicing from your leverage can really eat you alive. If your entire portfolio is sitting with only 10% equity in it, and the interest rates start creeping up like they are now, your expenses can quickly start exceeding your rental income, leaving you without the cash to carry on running your real estate rental business! I have seen this happening most recently in the Alberta rental market, as interest rates, insurance, and property taxes have all been going up and up, while rents have been dropping for the past few years.
Too much leverage can lead to you making poor property management decisions. Some examples of this would be just accepting the first tenant application you receive to fill a vacancy, even if you know they are not the right fit for the property.
Another example would be deferring maintenance due to lack of cash flow which will catch up with you eventually in higher repair bills and poor tenants for non maintained properties.
What is the right amount of leverage to use? The banks may have it right after all. I think that if you stay in the range of 30% equity/ 70% debt, you should be OK. This will differ dramatically by property and market, but this could certainly be used as a rule of thumb!
If you have any questions about rental property management in Vancouver, Burnaby, Edmonton, or any of the other markets we service, please feel free to reach out for some free real estate advice here!