Property Investment Secrets You NEED T0 Leverage For FIRE!

Property Investment is one of the investment vehicles we talked about in the previous post about ‘ Investing For Financial Independence – Shares, Real Estate & More’. Real Estate has long been a darling of many investors and you will find plenty of books, articles and advice on this subject. Property has long been believed to be a safe investment, hence conjuring the term ‘safe as houses’

Property Investment can feel very real as its a tangible asset that you can touch and feel. Also we all live in houses, go to business premises and work in offices, so we are well familiar with Real Estate. But is Property Investing a way to get to that magical financial freedom?

If you look at it from a pure investment point of view, real estate does have the ability to generate an income that can be relatively passive. Once you buy that rental property and get a tenant setup, you don’t have to go there every day to check if everything is fine. If you manage it yourself, you may have to go there once in a few months or even less. Sometimes, you may have a high maintenance tenant that requires more frequent visits but it certainly wont be on a daily basis. So, by that definition, real estate can be an asset that derives an income which can be used towards your financial freedom.

Property Investment vs Your Own Home

A key distinction we have to point out is property investment and your own home. Both your own home and an investment property are real estate asset classes. However, both are not investments as such. Although a lot of people consider the home as the biggest investment of one’s lif, we don’t see it that way.

The pure definition of an investment is an income producing asset at the most basic level. Investopedia defines an investment as an asset or item acquired with the goal of generating income or appreciation. If you use this simple definition on your own home, it just does not fit. Your home does not really product an income. Sure you can produce an income from your home if you sent out part of it but generally that is not that case.

The part that is debated often is the appreciation part of the definition of an investment ‘generating income or appreciation‘. Many would argue that your own home does appreciate in value over time, hence giving you more money than you paid for it when you bought it. In theory this is true but there are a LOT of variables that need to be considered

If you bought your own home with cash and are in an area that is quite sought after by others the chances are that you will experience capital appreciation on your house. So if you say sell it after 10 years of owning it, you will likely get more than you paid for it, sometimes even double or more! Of course, you still have to live somewhere, so its not all profit that you can live off.

On the face of it, investing in property may look like a lot of other investment vehicles, with its own set of advantages, disadvantages and risks. However, there is one key secret ingredient of property investment that is often forgotten but very powerful. This secret ingredient is leverage and is something that is not as available for most other investment types.

So what is leverage in real estate and how do I use this secret power of property investment? Leverage is simply where investors borrow some or all of the money needed to buy real estate. The money is often borrowed from a bank or similar source. The power of leverage is that the investor can buy more real estate than they would be able to if they just used their own cash.

So at a basic level, leverage allows an investor to buy the property that they would not normally be able to afford. This is a tremendous advantage in itself but that is not the only magic of leverage worth mentioning. Leverage also allows the compounding of any gains from the property, which again would not have been able to be enjoyed by the investor if they had only used their own money.

Leverage is best described with some real examples, so say you had $100,000 to invest in real estate. You could use that $100,000 to buy one property, if there were properties that were available in the area you were looking for in that price range. That one property would allow you to get a return if you rented it out. For arguments sake, lets take it as getting a 5% return after expenses, which would be $5000 over a year. So on your $100,000 investment you would get $5,000 return on a yearly basis.

Now lets look at the alternative scenario where you use the initial $100,000 as deposit to borrow money from the bank. The banks generally look at the deposit and your income to pay off the loan with interest. So assume that the bank is able to lend you $300,000 with your $100,000 deposit. If you were looking in the same area, you could use the total of $400,000 to buy four properties, each worth $100,000. Assuming the same return on each property ($5,000), you would expect $20,000 in rental return on a yearly basis. Of course, you would have to pay the bank the interest on the loan, which for this example we will take at 3%. So you would pay the bank $9,000 in interest, leaving you with $11,000 of rental income.

The other part of leverage is the potential compounding capital growth that you can achieve. Carrying on with the same example as above, lets assume that after 10 years, the value of houses in that area doubled. So if you take the cash only option, the $100,000 property would be worth $200,000 after 10 years. That would be a $100,000 capital gain profit at the end of the 10 years if you sold the property (ignoring transaction costs to make it simple)

Now lets look at the capital gain of the leveraged scenario if the house values doubled over 10 years. In this scenario, you had borrowed $300,000 from the bank to top up the $100,00 in cash to buy four properties. After 10 years, these four properties would each be worth $200,000. The total value of the portfolio would be $800,000. If you paid back the bank the $300,000 owed, it leaves 500,000. Take out the initial cash of $100,000, that leaves $400,000 in capital gain profit at the end of the 10 years if you sold the property (ignoring transaction costs again)

So in the leveraged scenario, you would have made $400,000 capital gains but if not leveraged, you would have only made $100,000. So quite a significant difference in gain. And that is the magic of leverage and compounding. You are basically using other people’s money to buy more assets than you would have otherwise and potentially made that higher profit.

Hopefully you can see from the above examples that leverage is a very powerful tool that a lot of investors use in real estate investing. It certainly is the top benefit of investing in property. But like anything, it comes with its set of risks that you should be aware of. Leverage in real estate is about using money from others to expand your portfolio. Of course, if you borrow money from others, you will be expected to pay interest on that money, its not going to come for free. There are some situations where you may get money lent to you with no interest to be paid but that’s usually in a family or close friend situation and would be very rare.

Generally, there will be interest and costs associated with borrowing money. For example if you borrow money from the bank, they will change you the interest rate at the time. You will also have to pay back the principle of the amount that has been borrowed. There will also be some costs associated with getting the lawyers to draw up and check the documents associated with borrowing.

The banks will also check your financial position to see if you are in the position to be able to repay the loan with the interest. So you will be expected to show a stable income and the ability to meet the commitments. They will also take the property itself or your own home as a security for the loan. So if you cannot pay back the loan for some reason, they have the option to take possession of the property or house. This results in mortgagee sales, which we talk about a bit further down in this blog.

Of course, if you are borrowing for an investment property, the rent you get should be a decent contribution towards the interest that you have to pay. Sometimes, the rent is sufficient to pay all the rent and other expenses. And if you have done it well, there would be a surplus of the rent that you can put into your pocket, making it a positive cashflow property investment.

The downside of all this is if your income or rent stop, you are still stick with the commitment of the loan and its repayments. Banks are regulated and have a level of tolerance but if you have borrowed from non bank lenders, the tolerance will be lower. So if your situation changes once you have borrowed the money, that’s when the risk of leverage becomes an issue. Mostly you should be able to get a new tenant or a new job but in some cases, the market conditions may not be helpful. Thus making it harder to find a new tenant or a job and therefore replaying the loan.

If you cant pay the regular payments of the loan on time, the lender or bank will generally work with you to see what you can pay for a while. However, eventually if you can’t catch-up, they will take possession of the asset that was used for security on the loan, which could be the investment property itself or sometimes your own home. This would result in a mortgagee or bank ordered sale of the asset.

In such a sale, the lender has the right to sell the property to recover the loan amount and the interest owed on the loan. Often, this would be less than the value of the house as you would have been made to pay a deposit on the property as part of the loan approval. Generally, lenders give a loan on a property for a percentage of the value of the property, not the entire amount. Sometimes, that may mean you pay a 20% deposit and the banks give you the 80% as a loan.

So when it comes to a mortgagee or forced sale, the lender will be looking at getting back their loan amount and interest/costs, which could be less than the value of the house or what you paid for it. This means you stand to be at a loss as you wont have the house and would have lost the deposit you paid. So the idea is to never really get into the situation where your lender needs to take back the asset.

So inconclusion, although leverage and compounding are amazing, it comes with its set of risks that you must be aware of. It requirements planning and working through worst case scenarios to ensure you don’t get caught up and go backwards

Types of Real Estate Investments

Investing in property may sound quite simple. Buy a house, rent it out, collect the money, end of story. Right? Not quite. There is a lot more to property investment than just buy any real estate and just renting it out. There are many different ways of investing in real estate. Below we talk about some of the way used by ourselves and other investors

I. Traditional Rental Properties

Let’s begin with the evergreen method of property investment: traditional rental properties. This classic approach involves purchasing residential real estate with the intention of leasing it to tenants. Here’s a candid look at why it’s still a popular choice among investors:

Advantages:

1. Steady Rental Income: Owning rental properties provides a consistent source of income through monthly rent payments. It’s akin to having a dependable financial companion by your side.
2. Property Appreciation: As time marches on, properties often appreciate in value. This gradual uptick allows investors to build wealth through capital appreciation, creating a strong foundation for financial growth.
3. Tax Benefits: Rental property owners enjoy various tax deductions, such as mortgage interest, property taxes, and maintenance expenses. These deductions can significantly reduce your taxable income, lightening your financial load.
4. Equity Building: Every time tenants pay rent, you’re not only covering your expenses but also building equity in the property. This accumulated equity can be leveraged for future investments or other financial aspirations.
5. Portfolio Diversification: Real estate is a valuable addition to a diversified investment portfolio. It offers a safety net against market volatility, creating a balanced portfolio that can weather economic storms.

Disadvantages:

1. Property Management: Managing rental properties can be time-consuming and nerve-wracking. It entails tasks like finding and screening tenants, handling maintenance requests, and addressing tenant issues. It’s not always a walk in the park.
2. Market Variability: The rental market isn’t immune to fluctuations in supply and demand, affecting rental income and property values. Economic factors beyond your control can sometimes throw a wrench into your plans.
3. Property Expenses: Property owners must cover ongoing expenses, including property maintenance, insurance, and property management fees. These expenses can take a bite out of your profits, demanding financial discipline.

II. Real Estate Investment Trusts (REITs)

If you prefer a more hands-off approach to property investment, Real Estate Investment Trusts (REITs) could be your cup of tea. These are companies that own, operate, or finance income-producing real estate. Let’s explore why REITs have garnered attention from investors worldwide:

Advantages:

1. Diversification: REITs offer investors the chance to diversify their real estate holdings across various property types, including residential, commercial, and industrial. It’s like having a buffet of real estate options.
2. Liquidity: Unlike traditional real estate investments, REITs are traded on stock exchanges. This means you can buy and sell REITs with ease, enjoying the flexibility of liquid assets.
3. Professional Management: REITs are managed by experienced professionals who handle property management and operations. This relieves investors of the everyday headaches associated with hands-on property management.
4. Passive Income: REITs usually distribute at least 90% of their taxable income to shareholders in the form of dividends. This translates to a steady stream of passive income – a paycheck without the daily grind.
5. Accessibility: Investing in REITs requires less capital compared to purchasing physical properties. It’s a more accessible option for a broader range of investors who may not have the financial might to buy entire properties.

Disadvantages:

1. Market Volatility: Like any investment in the stock market, REITs can be subject to price fluctuations. This volatility might not align with the stability some real estate investors crave.
2. Limited Control: When you invest in a REIT, you have no direct control over the properties it owns or the management decisions made by the company. Your influence is akin to being a passenger rather than a driver.

III. Short-Term Rentals (Airbnb, Vacation Rentals)

In recent years, the meteoric rise of short-term rentals, thanks to platforms like Airbnb, has opened up new avenues for property investment. Here’s a closer look at this dynamic and evolving option:

Advantages:

1. High Rental Income Potential: Short-term rentals often command higher nightly rates than traditional long-term leases. This translates to the potential for greater rental income, a tantalizing prospect for investors.
2. Flexibility: Short-term rental property owners can use their investment property for personal use when it’s not rented out. This blend of personal enjoyment and income generation is the epitome of work-life balance.
3. Location Freedom: Short-term rentals can be established in various locations, including tourist hotspots. This provides investors with the flexibility to choose investment destinations that align with their goals and preferences.
4. Shorter Lease Terms: Unlike long-term rentals, short-term rentals typically have shorter lease terms. This allows property owners to adjust rental rates more frequently in response to market demand, optimizing their earnings.
5. Tax Deductions: Just like owners of traditional rental properties, short-term rental property owners may still benefit from tax deductions. These deductions can provide a welcomed financial cushion.

Disadvantages:

1. Property Management: Managing short-term rentals can be more time-intensive compared to long-term rentals. It entails frequent turnovers, cleaning, and guest communication. It’s not a hands-off investment strategy.
2. Seasonal Demand: The income from short-term rentals can be seasonal, with fluctuations based on location and tourist seasons. This seasonality can impact revenue predictability.
3. Regulatory Issues: Many cities have imposed regulations and restrictions on short-term rentals, often in response to concerns about property values, neighborhood character, and housing availability. Navigating these regulations can be challenging and may limit your investment opportunities.

IV. Fix and Flip Properties

For those with a knack for renovation and a keen eye for potential, fix and flip properties can be a thrilling venture in property investment:

Advantages:

1. Profit Potential: The essence of fix and flip lies in buying distressed properties, giving them a facelift, and selling them at a higher price. Done right, this can result in substantial profits in a relatively short period – the thrill of making a transformation and reaping the rewards.
2. Creative Control: Fix and flip investors have creative freedom. They can design and renovate properties according to their vision, potentially increasing property value through strategic improvements and aesthetic enhancements.
3. Learning Opportunity: Engaging in fix and flip projects can be an educational experience. It’s a crash course in property valuation, construction, and real estate markets. The knowledge gained is an invaluable asset for future investments.

Disadvantages:

1. Capital and Risk: Renovation projects can be capital-intensive, requiring significant upfront investment. There’s also inherent risk involved; not all renovations result in the expected profit, making it a riskier form of investment.
2. Time-Consuming: Renovation projects demand meticulous planning and execution. Delays and unforeseen issues can extend timelines, potentially impacting the sale of the property and your overall return on investment.
3. Market Fluctuations: The success of fix and flip projects can be influenced by market conditions. Timing is crucial, and market fluctuations can affect the selling price and your profitability.

Investing in property has been a well used vehicle for a lot of investors to get to FIRE over the years. Its popular as there is always demand for houses, as people have to live somewhere. Its also tangible as you can feel and touch a property and see it often. Leverage is another great reason people use property investments as you can grow your portfolio, your passive income and wealth significantly faster by using other people’s money. But like any investment class, real estate investment comes with its set of risks that you must understand and be able to have mitigation plans in place for.