Each investor has his or her personal risk tolerance level. This fact, combined with his or her specific real estate goals, will direct an investor in his or her decision regarding how much leverage to use within his or her portfolio. With leverage, and investor must find a balance between reducing his or her down payment and reducing his or her positive cash flow
 
Negative cash flow should be avoided in almost all situations as it will:
 
  1. Force you to work harder in other areas to create cash or income to feed this monthly cash deficit
  2. Dramatically reduce your ability to obtain mortgages on future investments
  3. Force you to rely on dramatic increases in property values or rental incomes (in other words turn you from an investor to a speculator)
 
None of these three situations are good news for a sophisticated investor and that is why a balance must be struck. 
 
Finding the balance
 
Thanks to the overall long-term stability of residential real estate investments, banks and other financial institutions are willing to provide you with relatively inexpensive financing secured against your investment property. This leverage can dramatically increase your return on investment (ROI) but, as with any investment, the higher you try to push your ROI the higher the risk.
 
Further into this article we will review three separate scenarios. The property remains the same, the holding period remains the same, yet the ROI increases as you factor in leverage options. Remember, maximizing ROI is not always the ultimate goal nor is always reducing the down payment to nothing. It is all about finding an intelligent balance of the two.
 
Here is a simplified example of how this can work on a real life property. For ease of analysis, we haven’t included the bonus of the mortgage principal paydown that would occur (except in scenario one) over the holding period of the property. In addition, as every investor’s tax situation differs we are only discussing pre-tax figures:
 
 

 

Purchase & Sale of Townhouse
Purchase Price                                                                                            $219,000
Sell Price                                                                                                    $319,000
Net pre-tax capital gain                                                                                 $100,000
Net Income (after operating expenses, before Financing)                                  $1,150/m
 
 
Scenario #1 – Purchased with cash, no leverage. 
Sold five years after purchase
Purchase Price                                                                                            $219,000
Sell Price                                                                                                    $319,000
Net pre-tax capital gain                                                                                 $100,000

PLUS
Net pre-tax income (positive cash flow)
($1,150 x 60 months)                                                                                    $   69,000

EQUALS
Net pre-tax capital gain                                                                                 $100,000
Net income (positive cash flow)                                                                      $ 69,000
Pre-Tax Profit                                                                                             $169,000
Overall (not annualized)                                                                           ROI     77%
 
 
Scenario #2 – Purchased with 20% cash down. 
Sold five years after purchase
Purchase price                                                                                          $219,000
Sell price                                                                                                   $319,000
Net pre-tax capital gain                                                                               $100,000
Down payment (20% of $219,000)                                                                $ 43,800

PLUS
Net pre-tax Income (1,150 minus $961 mortgage payment = $189)
($189 positive cash flow x 60 months)                                                           $ 11,340

EQUALS
Net pre-tax capital gain                                                                                 $100,000
Net Income (positive cash flow)                                                                      $ 11,340

Pre-Tax Profit                                                                                              $ 111,340
Overall (not annualized)                                                                            ROI   254%
 
Scenario #2 – Line of Credit For Down Payment
Purchased with 20% down (from LOC). 
Sold five years after purchase
Purchase price                                                                                         $219,000
Sell price                                                                                                 $319,000
Net pre-tax capital gain                                                                             $100,000
Down payment (20% of $219,000)                                                              $43,800
Down payment cost ($118.63 LOC payments x 60)                                      $7,118

PLUS
Net pre-tax income (1,150 minus $961 mortgage – 118.63 LOC payment)
($70.37 positive cash flow x 60 months)                                                 $   4,222

EQUALS
Net pre-tax capital gain                                                                        $100,000
Net Income (positive cash flow)                                                             $    4,222
Pre-Tax Profit                                                                                    $ 104,222
Overall (not annualized)                                                                 R.O.I.   1464%
 
 
       
As you can see, using leverage properly, in well-chosen markets can be a positive advantage that real estate provides you. However, you can also see that, when analyzing, there are many moving parts to the equations that must be considered. They include, but are not limited to:
 
  • Cash available
  • Source of down payment
  • Net income after expenses (before financing)
  • Interest rates (now you see how important a veteran mortgage broker is to your team)
  • Potential value increase (if any)
  • Number of properties you wish to purchase overall
  • Your cash flow goals
 
In other words, there will NEVER be a black-and-white answer to the question “how much should I put down?” The only way to get yourself close to this decision is applying the fundamentals, which includes choosing the right town and neighbourhood, analyzing the potential cash-flow scenarios, negotiating a good deal with your mortgage broker, managing the property well, analyzing… not guessing.
 
Why have I stressed the importance of cash flow over the last 17 years? Simply look at the scenarios above and remove the property value increase. Now we are selling at the same price we purchased (and this doesn’t even factor in inflation or time value of money, nor does it factor in any mortgage paydown):
 
Scenario 1           new profit =       $69,000                 ROI                         New 31.5% vs Old 77%
Scenario 2           new profit =       $11,340                 ROI                         New 25.8% vs Old 254%
Scenario 3           new profit =       $ 4,222                                 ROI                         New 59.3% vs Old 1,464%
 
Now what if the property went down 10 per cent in value and you still had to sell it at the five-year mark. In this scenario, you still received the cash flow, but at the end you have to subtract the drop in value:
 
Scenario 1           new profit =         $47,100                               ROI                         New 21.5% vs Old 77%
Scenario 2           new profit =       - $10,560                              ROI                         Loss vs Old 254%
Scenario 3           new profit =       - $17,678                              ROI                         Loss vs Old 1,464%
 
Yes, the old risk reward balance really starts to show when you look at the real numbers. And this is simply an example to illustrate that it is just as important to find a market that has strong underlying economic fundamentals as it is to find the right property. 
 
It also illustrates that if you plan on selling in the future (which some investors do) that choosing the right time to do so is important.
 
 
Importance of positive cash flow
 
As your cash flow increases your long-term risks decrease, as demonstrated in the above examples. Bottom line, cash flow (passive income) provides you with financial freedom as it can replace (or augment) your salary. Cash flow is the engine that drives your life while equity appreciation is the bonus that can come with a quality, well-chosen property, but should not be counted on. 
 
Positive cash flow can cover up many investor mistakes and help cover for potential vacancies or unexpected repairs.
 
That being said, using all of your capital to have zero mortgage on your property often isn’t to your bottom line advantage, as the examples showed. Always find the balance that works for you. There are regions in North America where you can achieve tremendous positive cash flow, yet very little (if any) equity appreciation and the reverse is also true. 
 
 
Both can be great investments, just don’t fall into the negative cash-flow trap, just so you can have ‘low’ down payment. Real estate is not about getting rich quick, it is about long-term wealth creation. Treat it like the active business it is.
 
Don R. Campbell is the bestselling author of Real Estate Investing in Canada Version 2.0.
100% of his Royalties Are Donated To Habitat for Humanity
 

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