Blog Post

Increasing Real Estate Return on Investment

Gaston Reboredo • Sep 25, 2021

Using Positive Leverage, other people's money to increase returns

How to increase return on investment in residential real estate by using debt financing.

I see many small residential real estate investors buying properties cash. To obtain the maximum possible return of a real estate investment an investor needs to review that he/she is renting the property at the maximum possible market rent, has a comprehensive maintenance program with cost reduction strategies and uses debt under a positive leverage situation.

The use of debt, such as mortgage financing, is a perfect way to maximize returns on real estate investments. The only way for this to work is in positive leverage situations.

Positive leverage is when a business or individual borrows funds and then invests the funds at an interest rate higher than the rate at which they were borrowed.

For example, if your total investment in a rental single family home is $200,000.00 and your net total income for that property a year is $10,000.00 then the yearly Return of this investment is 5%. This is the unlevered cash on cash return of the investment, also known as the Capitalization Rate ( Cap Rate).

If you are able to obtain a mortgage loan for the property with an interest rate below 5% this is call positive leverage and will increase the return on the investment but if the market interest rate is more than 5% this is negative leverage and will lower the return on the investment because the borrowed funds are costing more than what the investment is producing.

In other words the positive leverage calculation requires that you know the loan constant, which is the total annual loan payment (loan principal and interest) divided by the total loan.

The calculation is:

Loan constant = [annual loan payment] / [total loan amount]

If the loan constant is greater than the cap rate, it is positive leverage. If it is lower than the cap rate, it is negative leverage.

As an example calculation, assume a property is acquired for $200,000 and generates a net operating income (NOI) of $10,000 resulting in a 5.0% unlevered cash-on-cash return prior to using any debt. In this case, the cap rate is also 5.0% as explained above. Let’s assume we are obtaining an interest only loan.

If you as an investor are able to secure a 60% loan-to-value mortgage with an interest rate of 4.0% (interest-only), then total debt service payments would be $4,800 ($200,000 value times 60% LTV times 4.0%) and cash flow after debt service would be $5,200 ($10,000 NOI (net operating income) less $4,800 (debt service). Using debt, the investor would have contributed $80,000 of equity ($200,000 purchase price less $120,000 mortgage loan at interest only) which results in increasing the cash-on-cash return to 6.5% ($5,200 cash flow after debt service divided by $80,000 equity). This 6.5% is higher than the 5.0% cap rate and results in positive leverage.

The levered scenario obviously has a better return than the unlevered scenario. But is there a point at which using leverage is no longer a viable option? Yes — a higher interest rate can create a negative leverage situation. As an example, an interest rate of 5.2% would create an annual debt payment of ($120,000 times 5.2%) $6,240. $10,000 NOI less $6,240 debt service is $3,760. Then $3,760 divided by $80,000 is 4.70%, which is less than the 5.0% cap rate, creating negative leverage.

The use of leverage (financing) not only increases the return on the investment but also allows the investor in buying more properties because instead of putting the $200,000 as in our example above in one property, the investor can put 40% down payment which is $80,000 for a $200,000 purchase price and buy one property and be left with an extra $120,000 in hand to buy one or two more properties. This will not only dilute risk because now we have the funds invested in three properties maybe in three locations rather than all the funds in one property in one location but one of the great aspects of real estate investment is appreciation, values increase over time and are a great head against inflation and an excellent way to create wealth. For example if we use our total funds of $200,000 to buy two properties valued at $200,000 using 60% loan to value loans as in the example above, we are buying each property for $200,000 but with a down payment of $80,000 each and we still have $40,000 to buy a third property, let’s say valued at $100,000 using also financing on a 60% LTV, now we will own three properties, two valued at $200,000 and one at $100,000 so with the same $200,000 in cash, using leverage we now control $500,000 in real estate and if the appreciation rate is let’s say only 2% (usually is more than the inflation since there are many factors that influence property appreciation and not only inflation) we will be increasing our wealth by $10,000 every year since the value of all the properties ($500,000) will increase at 2%, rather than only the value of one property of $200,000 increasing at 2% which will create a wealth accumulation of only $4,000 a year instead of $10,000.

To calculate real returns of real estate investment we perform deeper analysis than the simple one here, taking into account the property appreciation over time as explained herein, then the return is composed of the yearly return after financing plus what the increase in value of the asset. This is the calculator of an Internal Rate of Return.

So in our example if we have a total return on our $200,000 investment in three properties would be the our 6.5% yearly cash on cash return plus the property appreciation ($10,000 increase in value, which is the 2% appreciation rate times the value of the three assets totaling $500,000, over our $200,000 total investment in the three assets) which is an additional 5%, so in a simple calculation we would make in one year a return of 11.5% over on our investment (6.5% plus 5%). Of course the portion of return allocated to the appreciation in value is not realized until we sell the property and we will have to take into account the selling costs and the time period from acquisition to the sale, which is what we obtain when we perform an Internal Rate of Return analysis. We will discuss Internal Rate of Return and Net Present Value and other topics of Financial Analysis in future blogs but the intent here is to illustrate how to increase returns on investment using real estate financing with positive leverage.

Gaston Reboredo CCIM CPM

< Older Post Newer Post >

Share this post

Florida Security Deposit Laws

By brittany • 25 Apr, 2024

Are you a landlord in Florida? Here’s what you need to know about security deposit laws!

The Evolution of Squatters' Rights

By Florida PMServices • 12 Apr, 2024

A historical Journey in the United States

Renting a Property before Current Tenant Vacates

By Florida PMServices • 12 Apr, 2024

No question that one of the secrets for success in rental investment real estate is to minimize vacancies and turn overs. The longer a tenant stays in a property the better return on the investment. Ideally a tenant will rent a property once and stays there forever, renewing the lease agreement year over year. We all know this would be the goal in a perfect world but we also know is not reality and tenants will someday move out because of job relocations, purchasing a home or many other changes in life. When a tenant gives notice to move out at the end of the lease, most landlords want to put the property on the market right away to avoid or minimize vacant days in between tenants. Especially when the existing tenant is a good tenant that has taken care of the property and behaves professionally. Although this would be ideal that the existing tenants moves out on the last day of the month and the new tenant moves in a couple of days later, we are going to discuss why this is not a good practice and it may work against our investment goals. Here are some issues with trying to market and lease a property while occupied: If the landlord or agent is going to show the property entering the premises with tenant's permission and prior notice, a potential liability is created. You are showing the property basically to strangers that walk around the unit while tenant's personal belongings may be exposed or at an easy reach. What happens if the current tenant calls you later for example, stating that her new expensive gold watch and some jewelry , that was kept inside a drawer in her bedroom, disappeared. Or that the cell phone that he left charging in the kitchen is no longer there after your showed the property yesterday afternoon. Over the years we have heard, and thank God it has never happened to our company, that incidents like this have occurred. Our President, Gaston Reboredo, remembers that back in the early nineties the Realtor Association of Coral Gables (at the time) issued a warning to Realtors that there were two professional thieves posting as a couple wanting to lease expensive homes in the area and while one distracted the agent the other one went through drawers looking and stealing jewelry. So many things can happen and this liability is present when showing occupied units. maybe not the most important issue of the ones we are discussing today but one that must be taken into consideration. If on the contrary the current tenant is present at all showings, then it becomes a logistic problem. How do you show the property during business hours? Most likely your existing lease agreement gives you the ability to show the premises with sufficient notice to the tenant but you cannot force the current tenant to leave work to go to the unit for a showing. Then during the evenings and weekends how many times you bother the tenant? and how many times the tenant is not available at the precise time the prospective tenant wants to see the unit. The existing tenant may be running errands at the requested time of showing and the alternative time offered by the current tenant may not be good for the prospective tenant so the whole matter becomes a logistic nightmare. Let's say the current tenant is always available to show the unit, which is not reality, then another problem arises. Even the best tenant the most organized and clean person in the world when it comes time to moving a process of packing starts, putting things into boxes, stuff and boxes all over the house preparing for move out date. It is not easy to show a property while the current tenant is in the process of preparing to move out and it is very difficult for the property to be properly presented to the prospective tenant and for this prospective tenant to really see the unit and see it as his or her new home. Besides the issues discussed, even if we can deal with the liability stated in item 1 above and we have permission to access the unit at any time, we face another problem. Again even the best tenants that are Mr or Mrs Clean, have to run to work or school in the morning and if we are talking about families now they need to get the kids ready as well, not having enough time to have the premises in the best possible condition for a showing. It is not rare that you arrive to show a property to a prospective tenant and the pots and pans are dirty in the kitchen sink, the smell of a recently cooked meal is all over the place, towels on the bathroom floor and beds not made, not to mention the underwear that was unintentionally left somewhere. And if we are talking about evening showings in the middle of family dinner, kids doing homework or tenants watching TV, who by the way did not have enough time to prepare the home when they got back from work, we are looking at not ideal situations to present a property. Difficult to attract good new residents if the property cannot be showcased professionally and in the proper way. Also if your properties are not properly presented you will not only be wasting time in trying to rent them but your reputation as a landlord in the Realtor and Leasing community will be affected. Then we need to discuss other potential problems that may end up in legal liability to the landlord. Let's discuss a scenario where the current tenant was very cooperative, present at all showings and the home was pristine at every showing. Let's say the current tenant is leaving at the end of the month because of a job relocation out of the City, or another location in the same City, needing to rent a closer unit to the new employment location or because of the purchase of a home for the first time, achieving the dream of homeownership. Then you sign the lease with the new tenant to start the new tenancy during the first few days of the following month after current tenant vacates. What if the new place current tenant is moving to is not ready or the Home Owners Association required approval has not been issued and the move in date has to be delayed and current tenant cannot leave the premises before the start of the new lease with the new resident? what if the closing on the first home is delayed due to the numerous reasons real estate closings are delayed? In both cases current tenant will remain in the premises and yes you may be able to charge double rent by law or by lease agreement but the only way to force the current tenant to vacate is through an eviction process which may take in South Florida 30 to 45 days or more, depending in the area and if it is contested or not by the tenant. Meanwhile you have a contractual agreement with the new tenant to deliver the premises at certain date which now is going to be impossible but the new tenant already gave notice to vacate to that other landlord and is obliged to deliver the premises at the expiration of that rental agreement or face the same liability of double rent, eviction, etc. And it does not stop here, the new tenant may have arranged and paid deposits to move in companies, scheduled utility turn on services, requested mail forwarding, etc. You can see liability, legal costs and problems all over a situation like this, that happens very frequently. These are sonly ome of the problems all landlords face when trying to rent a property while tenant occupied, thinking they will be able to eliminate or significantly reduce the vacant time. In summary, best practices call for avoiding to show properties while rented to existing tenants. Plan properly, have your maintenance team ready to come in as soon as the existing tenant moves out and turn, in a couple of days or so, the property into rent ready condition so you can start marketing it to lease showcasing it in a clean, professional way, to attract good new residents in the shortest possible period of time . A property that is properly exposed to the rental market will rent faster, for more money and to better tenants with the least amount of problems to all parties. At the end you want a good new resident that pays rent on time, takes good care of the property and renews the rental agreement for as lomg as possible reducing the vacancy to the minimum on a long term basis.