Thursday, August 26, 2010

What would be a save amount of leverage in a stagnating economy

Thomas Beyer wondered what a safe level of coverage might be for a real estate investment in a stagnating economy.

Investors such as Thomas know that rental rental properties draw their profits from different aspects. They are:
  1. Rental Income
  2. Operating Expenses
  3. Leverage (expressed often as a loan-to-value ratio (LTV)
  4. Mortgage (Interest) Rate
  5. Appreciation
Rental Income minus Operating Expenses make up your Net Operating Income or NOI.
You increase your NOI by increasing rent and/or reducing operating expenses. This does not take into account the effect of major property improvements on rental income.
Dividing your NOI by the purchase price results in your capitalization ratio or CAP Rate. Your total return on investment is determined not only by your NOI but also by the amount your property appreciates per year.  The amount of appreciation usually fluctuates (see the earlier postings such as on comparing stock market and real estate price volatility) but over the long term it goes up. I typically use the avaerage annual appreciation for a a Single Family Property in Calgary over the last 40yrs or so as a guideline (approx. 8%). However, you could use data from different time periods, such as the last 50 yrs, and come up with a more conservative 6%.
Some purist investors consider appreciation as the speculative component of their investment return and do not consider it in the property analysis. This may work for areas with high cap rates as often found in parts of Eastern Canada, but in Alberta and especially in Calgary, cap rates are lower, while the annual appreciation is or better 'was' typically higher - (in the East appreciation rates are closer to 6% rather than 8%).
When including these appreciation numbers in your evaluations and upon entering a stagnating environment, the purists may have the upperhand. Appreciation could in such an economy be a lot less than 8 or even a lot less than 6%. So although  leverage greatly magnifies losses and profits from appreciation or depreciation of a property, in this posting we only examine the effects of leverage on net cash flow and  on net cash flow plus mortgage principal reduction. When expressed as a fraction of the original purchase price these measurements are here referred to as Cash on Cash (COC) return (i.e. Net Cash Flow/Invested Cash) and as Return on Invested Cash (ROI on Cash or ROIC) which is Net Cash Flow plus Principal Reduction/Invested Cash).
It is important to realize that your true return on investment excluding appreciation comprises the cash left over after mortgage payments (Net Cash flow) and the principal reduction. Principal reduction is obviously a part of your profits, however, it is not cash that can be spend readily. To access it, you will have to sell the property or refinance it.
So if you have to live of your rental income during a stagnating economy without needing to sell of assets, net cash flow and COC are most important for immediate survival. In this analysis we will look at the effect of leverage on COC and ROIC.
Using a typical 2 bedroom apartment condo in Calgary as an example, we make the following assumptions: 

  • We got it at a really good price: $170,000

  • Rent is $1050 per month (not too shabby either) excluding electricity, cable and phone.

  • Condofees are $265 per month and excludes water, sewer, heating)

  • Property Taxes are $1084 per year

  • Annual maintenance of the unit $1000 (Condo Corp takes care of exterior and common areas)

  • Property management (which you can pay yourself or a professional manager): $882 per year.

  • Vacancy Rate 5% (even Boardwalk would not mind that!)

  • NOI = $5824 or a cap rate of 3.4%
 With an LTV of 75% and annual appreciation of 5% your TOTAL ROI would be 27% - WOW!
With an annual appreciation of 3%, TOTAL ROI would still be a Whopping 19%
And with 1% appreciation it goes down to an very satisfying return of 11%. Ahh the miracle of leverage!

 But what about COC and ROIC? Well, that is quite different. You may enjoy your 11, 19 or 27% total return, but what if you needed to live of the cash flow or ROIC upon refinancing?  Figure 1 shows the effect leverage has on your ROIC at a typical variable mortgage rate of 2.05% amortized over 35 years on your first year of operations.

Fig. 1 ROIC versus Leverage and for various mortgage rate scenarios.
As you can see, the higher the leverage the higher the ROIC. When mortgage rates increase however there will come a point that you turn negative. So if you don't care about net cash flow and appreciation, what would be your safety limit? The graph shows that even if the variable mortgage rate increased from 2.05% to 7.05% (unlikely in a stagnating economy), that your ROIC would stay above zero with an LTV of 50%.

 You may say, I don't see the variable rate ever, ever going up beyond 5.05%, in that case, an LTV of 65% should do. So you see, inspite of all the number crunching it is still up to you to decide as to what is right.

 Now, with a positive ROIC you still may have to pay cash out of your own pocket. If we truly want positive cashflow, the best you can get is the CAP rate without financing, i.e. an LTV of 0%. In our case, you max COC would be 3.4%. That is still a lot better than a money market fund and nearly as good as a 5 year GIC.  With increasing leverage your net cashflow goes down to zero and even negative. So our safety cut-off is zero or a COC of 0%. The graph in figure 2 shows that at 2.05% interest, you cannot have a leverage of 85% and higher or net cash flow will go negative. But if the mortgage rate increases to 7.05%, net cash flow would go negative at an LTV of 45%, while at 5.05% LTV should not exceed 55%.
Figure 2. COC return versus leverage for various mortgage interest rate scenarios.

 So, although risk tollerance lies in the eye of the beholder, my personal choice would be not to exceed an LTV of 55%. My spreadsheet tells me that, barring unexpected repairs, which always seem to happen at the most inconvenient times, that at 55%, I should be able to hold this property without having to put in cash. Even in the unlikely event of no appreciation, a stagnating economy and interest rates as high as 5.05% I should be able to get by. If we would have a more normal economy with 5% appreciation then my total ROI would be a respectable 16% meaning that if things go better than anticipated, I should still be able to enjoy the ride.


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