Power of Residential Property Investment

Using Financial Leverage is an excellent way to accelerate your financial growth. But to be a savvy investor you have to understand the leverage risk and learn to manage those risks.

More Leverage = More Financial Risk

Less Leverage = Less Financial Risk

You must not let the leverage risk scare you away from real estate investing because risk can be measured and controlled.

Where there is more volatility there is more risk. Volatility refers to more frequent deviations from the standard. To understand risk you have to understand volatility.

Real estate has the least volatility when compared to other investment venues. A study carried out has shown that during the past 10 years real estate was ten times less volatile when compared to stocks which tend to fluctuate wildly on a daily basis. Yet there is hue and cry and everyone freaks out when real estate prices go down by five to ten percent.

Even a highly leveraged real state is more stable than stocks. This will imply that real estate has less leverage risk than most other investments.

Even though real estate is very stable leveraging does increase relative risk.

More Leverage = More Returns = More Volatility = More Fluctuations in Cash Flow = More Fluctuations in Returns = More Risk

Let us say you buy a house at a price of $100,000 with cash down. If the price moves up by 10% in one year then you will make a profit of 10% on your investment. In this example we are not taking cash flow into account. If the price moves down by 10% then you make a loss of 10% on your investment.

In the second example let us say you had taken a mortgage of 80%. This would imply that you have made a down payment of $20,000 on the property. Now if the price moves up by 10% i.e to $110,000 then you will make a profit of $10,000 on your investment of $20,000. This will equate to a return of 50%. Similarly if the price of the property went down by 10% you will make a loss of 50% on your investment.

This example clearly shows the amplification of leverage risk by a factor of five times if the property has a leveraging ratio of 5.

What happens to the leverage risk if your property is purchased with No Money Down deal with 100% mortgage? Your profits will be infinity if the property prices moved up. Similarly your loss will be infinity if the property prices went down. But what is your risk if you have no money in the deal?

A study conducted in 1978 found that leveraged real estate is the only investment that is fully protected against inflation. This is because when there is inflation rents go up and there is capital appreciation. However mortgages remain fixed if they are for long term.

Many investors only look at the upside of financial leverage. Savvy investors try and cover the down side of leverage by taking steps to control it if things go wrong.

Leverage Risk Containment Strategies

You can contain the leverage risk by following the under-mentioned guidelines:

Reduce Financial Leverage Just Before the Market Peaks

Most novice investors start to use maximum leverage when the market is about to peak. This is the time for you to reduce your leverage risk by selling a few properties to pay off your mortgage and increase your equity on the other properties.

Increase Financial Leverage Just After the Market Bottoms Out

This is the time when most people have deserted the real estate market. But it is exactly during this period that leveraging offers the best capital returns in the medium to long haul. Interest rates are low, so the cost of borrowing is minimized. Financial institutions are looking for customers and it is easier to cut a better deal or get incentives from them. Sellers too are more motivated and more flexible on prices and terms of contract.

You should use the equity in your properties to buy more property. You should increase your financial leverage to the maximum because during this period you will have positive cash flow properties reducing your borrowing risk.

Buy Quality Properties

Always buy quality properties. A house or multi-family dwelling that is well maintained and well kept will hold up value better in the long run, and will save you money in maintenance as well. When the markets are down it will be easier for you to find quality tenants willing and relocate into a nice-looking property. Quality properties reduce your leverage risk.

Take the profits and pay down the debt

Greed is always dangerous in any market. This is where most people fall. Do not keep reinvesting your profits to buy more property. That is like betting all winnings on every new roll of the roulette wheel. If you follow this strategy you will lose your winnings because sooner than later markets will move downward. If you do not stand on solid foundation you will lose your profits. The best and safest strategy is not to keep borrowing against your equity. Use cash-flow to pay down the loan or to wait for prices to increase and then sell for a profit to reduce your debt.

Shop for the lowest possible interest rate

Even though the interest is tax deductible you still have to pay some of it out of their own pocket. It is always advisable to shop for the best deal available, using the services of a good mortgage broker. If your loans are substantial the savings could amount to several thousand dollars every year.

Make improvements to your property to increase cash flow

Make improvements and add value to your property to increase the rents so that you have positive cash flow leverage on the property.

Deposit Recycling to reduce Leverage Risk

If you buy a property with no money down you have no personal risk as long as the purchase is structured in such a way that you have no personal liability.

It is not always possible to buy a property with no money down. At times you will be required to put some of your money into the deposit. Your aim should be to take out your personal money from the investment as soon as possible. You can then use this money to buy some more property. This is known as deposit recycling.

The best way to recycle your deposit is to firstly buy the property below market value and then make improvements to increase its value and cash flow. You should then refinance the property and take out your deposit as soon as possible. Your leverage risk becomes zero once you have none of your personal money in the property.

Once you recycle your deposit to reduce your stake in the property (eliminate leverage risk) you should allow the equity to build in the property through appreciation and repayment of loan through the cash flow generated from the property. Do not get greedy and keep taking out loans against the equity in the property.

Reduce Leverage Risk as you grow older

You can apply more leverage when you are young because time is on your side. In case things go wrong you can re-start once again. As you near your retirement age you should reduce leverage risk. Once you are retired leverage only to the extent to reduce your taxes.

Leverage Risk as function of your personality

Each one of us has a different risk profile. Some of us are comfortable at taking more risk than the others. You should study your risk profile carefully and take leverage risk to the extent you are comfortable with. You will have peace of mind.

You may also like to read about Cash Flow Leverage, Appreciation Leverage, Financial Leverage and Mathematics behind Leveraging.

You may also like to read about Cash Flow Leverage, Appreciation Leverage, Financial Leverage and Mathematics behind Leverage

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