INVESTMENT PROPERTIES

I've never believed in advising or serving clients in the pursuit of something I haven't done myself, and so my wife and I have in recent years purchased, and now manage, our own cash-flowing (yes, even at today's rates!) leveraged investment properties in various markets of northern BC. Soon after my own forays started, I began helping interested clients, with some now owning multiple properties that I have captured for them at this point.

How does it work?

*CAVEAT: there is of course much more to leveraged real estate investing than the below 'back of the napkin' explanations. I feel this is a very 'learnable', digestible and much more approachable way to build wealth than most folks believe, so my aim here is to demystify perhaps, and to encourage. I can suggest a whole library of books or resources for you to self-educate yourself with if you wish, just ask.

In a nutshell (IMO), you are using a bit of your own capital plus leveraged funds to secure a very large and most likely appreciating asset (the property) that contains within it a profitable housing business (the rental or rentals), where the profit, in turn, more than covers the cost of the leveraging (mortgage interest) plus any principal paid back. IE, the rental income minus all the expenses leaves more than enough left over to cover the mortgage payment AND leave you with some positive cash flow each month (cash in your pocket to either spend or re-invest).  

NOTE: THE "INVESTMENT" IS NOT THE PURCHASE PRICE OF THE PROPERTY; THE INVESTMENT IS THE 'CASH UP FRONT', IE DOWNPAYMENT PLUS CLOSING COSTS PLUS ANY IMMEDIATE IMPROVEMENT/REPAIR COSTS. THIS IS THE AMOUNT WHOSE PERFORMANCE IS BEING MEASURED!

Your returns are earned and measured three different ways, two of which are reasonably reliable and forecastable (cash flow, loan repayment), and one of which is somewhat speculative (appreciation).  Here's a further breakdown, based on a reasonable 'real world example' presuming a $350,000 property that earns $2,500/mo in rental income; typically, the investment here would be about $80,000 (20% down plus closing) plus leverage in the form of an 80% mortgage ($280,000, in this example);

1) Principal paydown: a mortgage payment is comprised of both interest and principal. So, if the payment is $1,500/mo (5% on a fixed rate with 30yr amortization against a starting principal of $280,000) and roughly $400 of this is going to principal, this example would result in roughly $4,800 of gain over a year.

2) Positive cash flow: presuming the monthly rental income is greater than the sum of the expenses plus the mortgage payment, you will have money left over. So, if the rental income is $2,500/mo and the expenses are $800/mo (items such as management, 1/12th of taxes, insurance, maintenance) and the mortgage payment is $1,500/mo, than $2,500 - $800 - $1,500 = $200/mo of positive cash flow, or a further approximately $2,400 of gain over a year.

3) Appreciation: this is the much more speculative portion of your return. If the market can reasonably, based on history and future indications, be forecasted to rise at roughly 3.5%/yr and the property was valued at $350,000, you will likely gain over $10,000/yr. IT IS VERY IMPORTANT TO NOTE that this is $10,000 earned, NOT on the property's value, but on your INVESTMENT, which is the downpayment and closing costs. EG, for this property if presuming downpayment was $70,000 (20% of $350,000) and closing costs were $10,000, the 'investment' that you're measuring the performance of is $80,000. Appreciation is the LEAST reliable source of profit... however, in the long run, it quite often ends up having been the most profitable.

So, let's summarize the above reasonable scenario; this opportunity, with an investment of just under $80,000, in a year earns roughly $4,800 in principal paydown, $2,400 in positive cashflow, and $9,000 in appreciation, resulting in approximate overall investment growth of around $16,000 (if NOT selling the property in this particular year we are 'measuring'). In this scenario, the overall rate of return (vis-a-vis stocks) would float around 14-16+% presuming a roughly 5-10yr hold, and your investment would double around the 5-year mark.

Leverage (IE, using a lender's money) is the key to making each dollar work its hardest. After all, this is how the banks make money... they pay us a little to 'hold' our money, then invest it elsewhere for more. They are 'leveraging' our money. 

Leverage in real estate investing refers to using borrowed funds, such as a mortgage, to finance a property purchase. By utilizing leverage, investors can control a larger asset value with a smaller initial investment. The goal is to generate returns on the total property value, not just the initial investment. If the property appreciates in value, the investor can earn a higher return on their invested capital. However, it's important to note that leverage magnifies both potential gains and losses, as the investor is also responsible for repaying the borrowed funds with interest.

IMPORTANT NOTE: IMO, it's best to focus on what's INSIDE the 'asset' as much as or even more than the 'leveraged appreciation' that the asset HOPEFULLY (i.e., SPECULATIVELY) earns. By 'what's inside,' I'm referring to the accommodation/rental business... if this is reliably quite profitable, then an investor has far less concern about how the real esate market is performing.

Conventional thinking is that it's best to own a property outright; no debt, with maximum cash flow left over after paying monthly expenses. This conservative approach can work quite well and is a more secure, low-risk strategy. For context, in the markets I operate in, such a strategy of using 100% capital might result in returns on each dollar of roughly 6% to 11%, which can be quite satisfactory. Now, if instead one deployed a combination of, eg., 20% capital and 80% leverage in these same markets, very foreseeable returns from around 13% to 20% (and higher) on each dollar can be found.  To access these higher returns, leveraged property investors make decisions based on their appetite for risk, with the main risks of course being elevated interest rates or needing to sell during a potential dip in market value. 

For investors that choose leverage, the positives are as follows:

• Capturing the right to appreciation on 100% of the market value of the property while only needing to deploy capital equivalent to a small percentage of its purchase price. EG; let's say you (Mr. L for Leverage) and a friend (Mr. C for Capital) each want to invest $100 into the same market that happens to be appreciating at 5%/yr.  Your friend puts his $100 in. You put $20 of your own in but borrow $80 at a cost of $2. After 1yr you will have made $5 on $20, not $5 on $100, which means a 25% return on your $20 rather than a 4% return on $100. But wait... there was also that $2 interest you paid in order to borrow that other $80! So you ACTUALLY 'only' earned a net of $3 on your $20 instead of $5, which means a final yield per dollar of 15%. In this scenario, even after the leverage cost ($2 interest) is factored in, the leveraged investor earned triple the returns on each of their $20 than the non-leveraged investor did on each of their $100... and still had $80 left over to invest elsewhere.
• Being able to 'multiply' the value of your portfolio. EG, $500,000 holding five $500,000 properties with 20% down each means earning appreciation on a $2.5m portfolio and owning 5 accommodation businesses, versus $500,000 holding one $500,000 property and one accommodation business..
• More easily being able to diversify, or to minimize having too much exposure in one property or area. EG, holding more properties in various markets vs less properties in one market.  

And the negatives:

• Market Volatility and Property Value Fluctuations: When using leverage in real estate investing, property value fluctuations pose a significant risk. Suppose the market experiences a downturn or the property's value declines. In that case, the investor may face difficulties in meeting mortgage obligations or be at risk of negative equity, where the property value is lower than the outstanding loan balance. This can lead to financial losses and potential foreclosure if the investor cannot cover the mortgage payments.  Let's use the Mr. L. and Mr. C. scenario again: THE RISK for Mr. L would be if the market value dropped from $100 to, say, $70, and both Mr. L and Mr. C had to sell... now Mr. L has lost his $20, PLUS owes another $10, and still owes $2 interest... OUCH.  *THIS is exactly why, with leveraged property investing, one must focus VERY much on the quality of the business that is 'housed' inside the leveraged asset... if you're earning a great rate of return just from your operating profit, you have the option to (likely quite comfortably) just sit out a market dip. This is also why, for myself and despite the higher capture costs, I much prefer newer, more appealing properties that will be easier to keep tenanted during a potential 'down cycle.' 

• Interest Rate Risk and Financing Costs: Leveraged real estate investments are sensitive to changes in interest rates. If interest rates rise significantly, it can increase the cost of borrowing, resulting in higher mortgage payments and reduced profitability. In some cases, rising interest rates may make it challenging to refinance existing loans or secure favorable financing terms for future investments. This interest rate risk can affect the investor's cash flow and overall returns on the investment. This risk can be mitigated by being strategic and conservative when choosing a mortgage product, for example accepting lower cash flow in exchange for the higher security of taking a longer-term fixed rate at a higher interest rate.

If you've read the above sections and are still with me, there are some main metrics and language that, if you're not already familiar with, you'll want to be as you start evaluating opportunities yourself or having a professional (such as yours truly!) present to you...

● Cap Rate: in a nutshell, how much does the property earn relative to the purchase price. Drier version... 

Cap Rate, short for Capitalization Rate, is a common financial metric used in real estate investment to assess the potential return on investment. It is calculated by dividing the Net Operating Income (NOI) of a property by its current market value or purchase price. The resulting percentage represents the expected annual return on the property's investment value.

The formula to calculate Cap Rate is as follows:

Cap Rate = (Net Operating Income / Property Value) x 100

The Net Operating Income is the property's annual income generated from operations (rental income, minus operating expenses like property taxes, insurance, maintenance, and management fees). The property value represents the current market value or purchase price of the property.

Cap Rate serves as a tool to compare different investment opportunities and assess the relative attractiveness of a property. Generally, a higher Cap Rate implies a higher potential return on investment, as a larger portion of the property's value is expected to generate income. However, it's essential to consider other factors like market conditions, property type, location, and potential risks before making investment decisions solely based on Cap Rate.

Cap Rate is commonly used in commercial real estate, but it can also be applied to residential properties or other real estate investment types. It helps investors evaluate the income-generating potential and relative risk of an investment property, aiding in the decision-making process.

● Cash on Cash: in a nutshell, how much does the property earn relative to the cash up front (downpayment+closing+immediate repairs/renos). Drier version...

Cash on Cash (CoC) is a financial metric used in real estate investment to assess the cash flow generated in relation to the amount of cash invested. It measures the return on the actual cash invested, rather than the overall property value.

To calculate CoC, divide the annual pre-tax cash flow by the total cash investment (down payment and any additional expenses):

CoC = (Annual Pre-tax Cash Flow / Total Cash Investment) x 100

The resulting percentage represents the annual return on the invested cash.

CoC is a useful metric as it provides a straightforward way to evaluate the profitability of an investment and compare different properties or investment opportunities. It allows investors to assess the income generated from rental properties or other real estate investments in relation to the cash they have put into the investment. Higher CoC percentages indicate a higher return on the invested cash.

It's important to note that CoC does not consider factors such as property appreciation or tax implications, which are relevant for a comprehensive analysis of investment returns. Therefore, it should be used in conjunction with other metrics and considerations when evaluating real estate investment opportunities.

● IRR or Internal Rate of Return: in a nutshell, if looking for an all-encompassing metric to most directly relate stock market predicted or ongoing performance to investment property predicted or ongoing performance (IE, how should each dollar perform 'day to day'), this is the one. More nebulous than CapRate or CoC, but fully inclusive of all factors. It measures the annualized rate of return an investor can expect to earn on their invested capital (their 'cash up front') by considering NOI, projected appreciation, projected inflation and income appreciation, and more. 

● ROI (Return on Investment): in a nutshell, if you sold in 'x' years, how much more $$ would you have than when you started. Drier version...

ROI, or Return on Investment, is a financial metric used to evaluate the profitability of an investment property relative to the amount of capital invested, at a specific point in time (typically upon sale). In the context of leveraged residential real estate investment, ROI measures the return earned on the total invested capital at time of asset capture (the "cash up front.")

To calculate ROI in leveraged residential real estate investment, the formula typically used is:

ROI = (Net Profit / Total Investment) x 100

The net profit will be measured as sale price plus all income generated from the investment, minus operating expenses, mortgage INTEREST, remaining principal, and any other relevant costs (renos, repairs, etc.) up to the time at which the ROI is being measured (IE, upon sale). The total investment includes the investor's down payment, closing costs, and any other expenses incurred to acquire the property initially.