Sunday, December 28, 2014

How much leverage do I need in real estate? BTW Is anyone looking for a pension plan indexed for inflation?

If you buy an asset that rises 15% per year in value and you use only half your own money while lending the rest, you’re making close to a 30% return that year.  Especially if the interest costs of the loan is covered by net cash flow generated by that asset.

If you only put 20% of your own money down and borrow the remainder, that same asset will return 5 times 15% or an absurd 75%. So why not borrow 80% and go for this investment?  Well… what if… the asset loses 20% in value instead? Oops, the asset is worth only 80% of your original investment and that is what you borrowed from the bank!  So how much is left of your 20% down payment?  The answer: Nada, Nothing, Zilch, Zero!  Your loss is 100%!  Hmmm.
That is why many consider leveraged investing high risk. And it can be! Look at the stock market.  Say you bought $80,000 to invest $100,000 in a high flying oil company last month?  Ouch, those companies dropped often 30 or 40% in one month. So, your oil investment today is worth say $65,000 and that wipes out your $20,000 plus you owe the bank $15,000! Many real estate millionaires have bitten the dust because of leverage and remember the stories of 1929 when people jumped out of tall buildings during that market crash? Yep that is leverage at work.
Some say, that real estate is stable and much less volatile than the stock market. Maybe, but remember the U.S. 2008 real estate bust?  Did you ever buy that piece of recreational real estate in Whistler?  Did you own real estate in Calgary 1982 when that market dropped nearly 30% in less than three months and 50% during that entire debacle? 

So, what is better for investors, real estate or bonds or stocks?  To be honest, I don’t know. They all have their good and bad days. I do know that over the last 40 years or so Calgary real estate and also real estate in other parts of Canada appreciated 3 to 6% per year on average. I also know that the net cash flow in Calgary from rental properties prior to mortgage payments varies between 3 and currently 4.5%. Real estate investors call that the ‘cap rate’ which is current operating profits (comparable to the EBITDA of many companies) divided by the current market price of the real estate asset.
Jeremy Siegel has studied stock market performance over the long term in his classic book: “Stocks for the Long Run”. He has done so in each of his numerous updated editions. He calculates that stocks are the best performing financial asset you can invest in and that it outperforms bonds, T-Bills, Gold, GICs and whatever you have. Its long term return is 7% plus the inflation rate.  So currently the inflation rate in Canada is around 2% and thus the stock market's average annual return should be around 9%. Jeremy’s work is based on U.S. stocks but others have compared his work with international stock markets and get similar results. So let’s use Jeremy’s number of 9% (including inflation) and see what leverage it takes to make the same returns in real estate.
I made this little spreadsheet (see below) and ran 4 annual appreciation rate scenarios for real estate. I also used the current Calgary Cap Rate of 4.2%. I calculated how much leverage you need to make a return equal that of Jeremy (9%). The results are shown in the table below. The input data is Jeremy’s and shown in yellow. The Loan-to-Value ratio (i.e. the loan amount as a percentage of the purchase price) in the blue fields expresses how much leverage is needed if real estate appreciates by 3, 4, 5 or 6% per year on average to achieve the same returns as Jemery's.  The current cap rate is set at 4.2% which I currently achieve on my rental apartments in Calgary. In the last portion of the sheet, in the white fields you can see how an older 2 bedroom Calgary apartment, typically valued at $220,000 cash flows after making the loan payments).
The loan payments are based on the assumption that each $100,000 borrowed results in a loan payment (interest and repayment of principal) of around $500 per month.

 
I found the results revealing if not shocking! Last year, Calgary real estate appreciated by 10% but over the long term, it is closer to 5%. Basically, with the current cap rate, an investment would not need any leverage to equal Jeremy’s long term stock market and $9,240 of the profits would be returned as cash!  He, anyone wants a GIC?  J 
Even with modest appreciation of 3%, to equal stock market performance only a leverage level of 28.6% would be required and your property would still throw off $5,468 in cash ignoring the principal that is being repaid as part of the loan payments! Considering a repeat of Calgary’s worst real estate price decline in the 1980’s of about 50%, no lender would recall the mortgage with this leverage level and you could easily outwait the crash to rebuild your profits.
So, for a conservative investor who wishes a return comparable with the stock market and probably a less volatile investment on a day to day basis, what are you waiting for?  Before closing this post I would like to point out two more things.

When you invest in stocks, you have leverage involved. Many companies have substantial debt on their balance sheet – debt that is not under your control but your stock value can get wiped out because of it.
Secondly, with this kind of leverage (4.8% LTV) 6 properties or 1.3 million in real estate investment would receive close to $50,000 per year in cash to live from as a retiree.  Hmmm, combined with Canada Pension and Old Age Security that is not a bad retirement income don’t you think so? And this retirement plan is indexed to inflation!

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