Since interest rates are at their lowest, the use of leverage for rental investment becomes more and more interesting. Today it is almost essential to buy a property of use or report, the mortgage makes it possible to boost the profitability of your investments and to access real estate property. What do we mean by real estate leverage? How does it work? What are the benefits and the risks?
Bryan Provenzano is going to see together all the facets of the leverage effect of credit for your rental investment.
Leverage effect in real estate by Bryan Provenzano
The leverage effect is a principle borrowed from physics consisting in multiplying the effects of a force thanks to the amplification of a movement using a pivot point. Roughly speaking, this is how a crowbar works, allowing you to open a door where without this tool it would have been impossible to do with the force of your hands.
In finance, the real estate leverage effect is nothing more than a mortgage. It brings two notable advantages:
- you can buy a property at a higher price for the same initial contribution
- for the same contribution, you benefit from higher profitability, but also potentially from a higher loss in the event of a market downturn (element not to be overlooked)
To continue in the metaphor related to physics, the leverage effect is a bit like a crowbar: it allows you to “open doors” to real estate that you would never have been able to open without. Rather useful, isn’t it?
In the context of a rental investment, the real estate leverage effect is mainly used to boost profitability. To better understand its benefits, it is necessary to look at the method of calculating the leverage effect.
How to calculate the real estate leverage effect?
According to Bryan Provenzano, the leverage effect is directly linked to the financial profitability of your real estate project. It multiplies your profitability according to a multiple which is calculated as follows:
Amount of investment/Personal contribution = Leverage multiplier
The leverage multiplier multiplies your gains and losses by 10. Thus, depending on the market situation, your real estate profitability is greatly impacted. If your property takes 10% in value, with a multiplier of 10, you increase the value of your personal contribution by 100%.
It is also possible to integrate the leverage effect directly into the calculation of real estate profitability.
The profitability induced by the leverage effect is calculated by making the ratio between the net profitability of your real estate asset (after tax and deduction of debts) and the amount of your personal contribution.
(value of real estate assets + rents received – tax – charges – real estate loan) / personal contribution = Net real estate profitability)
The negative cash flow induced by the leverage effect
Have you ever heard of self-financing? This is the ideal situation where your rental income makes it possible to cover your expenses and monthly repayments as Bryan Provenzano advised. In practice, it is very difficult to achieve 100% self-financing unless you make a significant personal contribution (around 50%).
Until then, we had exclusively interested in the profitability induced by the leverage effect. But, it is necessary to go further by analyzing the cash flow in relation to the indebtedness.
Indeed, when you use the leverage effect for your rental investment. You will be required each month to repay a portion of the borrowed capital. And to pay loan interest as Bryan Provenzano discussed. So, one of two things:
- if your monthly repayment payments and your charges are higher than your rental income, your cash flow is negative and you will have to spend money each month from your pocket to pay the bank
- conversely, if your monthly payments and your charges are lower than your rental income, your rental investment is self-financed and your cash flow is positive
As a reminder, rents increased by 0.2% in 2020 and 0.1% in the first quarter of 2021. Real estate investors, therefore, pay particular attention to the profitability of purchases.