A balancing act: Leverage v.s. cashflow
Posted in the Foreclosures Forum
Since: Mar 12
#1 Mar 23, 2012
There is always a fine balance between leverage and cashflow. Leverage is one of the key benefits of investing in real estate. It's a way of reaping the rewards of the value appreciation on a property while using only a small amount of your own money in the form of your down payment.
However, an astute investor recognizes the importance of having adequate cashflow. Although the idea of getting into an opportunity with no-money down may seem appealing, itís important to recognize that the more leverage you use, the less cashflow you will see.
During prosperous times this may be okay; however, all you need is an unexpected vacancy or untimely repairs and you will quickly watch your reserve funds dwindle. Think of cashflow as the tap that constantly replenishes your water supply. It helps keep you afloat when times are tough.
Letís take a look at a quick example to show the impact of purchasing a $150,000 property with a 25% down payment versus a no-money-down purchase. In the no-money-down scenario, letís assume that the investor negotiated a vendor take-back mortgage (VTB) with the seller for 25% of the purchase price.
Scenario 1 Ė 25% down
Scenario 2 Ė No money down
(5yr fixed at 3.25% per year)
Vendor Take Back Mortgage
(6% per year, interest only payments)
Monthly Cashflow Calculations
Based on the above example, itís clear that with an unexpected vacancy the investor would have to carry a much larger load with no money down. Also, the VTB payments are interest only. This means that at the end of the term they would have to make a balloon payment, which they may not have, especially if the property value hasnít appreciated enough for them to be able to re-finance and pay out the VTB.
So, although it would be enticing to start investing without any money down, the ramifications of doing so could leave a bad taste in the investor's mouth if ideal conditions arenít met. Make sure there is sufficient cashflow to cover the additional burden of the VTB.
As Canadians, we pride ourselves on our financial conservatism. Most recently, the strength of our banking system has helped Canada weather the recent global economic turmoil. Canadians recognize the importance of maintaining an appropriate amount of equity in our properties and we do this by usually making a minimum 20 - 25% down payment. The point is that we recognize that leverage can be a powerful tool but has to be used wisely.
Having investment properties that provide positive cashflow means that you are getting a real return on your money today. Itís actual cash that goes into your pocket every month. Whereas, the other real estate profit centers are longer-term and canít be accessed as easily. Appreciation and mortgage pay-down provide a return on your investment, but itís not a return that you can appreciate until you either sell, or re-finance your properties.
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