The 'L' word

What is Leverage? By definition it is; A method of financing an investment by which an investor pays only a small percentage of the purchase price in cash, with the balance supplemented by borrowed funds, in order to generate a greater rate of return than would be produced by paying primarily cash for the investment; the economic benefit gained by such financing.

So why is Leverage such a dirty word?

Canadians have been pounded over the head lately with this concept of being over borrowed. Our debt coverage ratio is the highest it's ever been - oh my! The debt ratio is based on the notion that a person’s debt should not exceed what they earn in a year. On the surface that sounds like conventional wisdom, good, safe, I only pay cash mentality that many Canadians have adopted. Can we really lump all debt together? Isn’t there a difference between mortgage debt and consumer debt?

What happens when we examine the debt coverage ratio of Canada’s wealthiest real estate investors? People that own multi-million dollar portfolios, the ones we should be taking advice from. You will find that almost all of them strategically employ mortgages on each property they own. In fact they have it down to a science in that as soon as properties get too high in equity, the return on that equity falls below their acceptable level and they refinance. They then take the cash, get another loan, and invest in more property. Funnily enough, the highest net worth people you will encounter have debt coverage ratios so far out of whack that it would make your head spin. Ask them how they sleep at night. Let me tell you, they sleep like lumber in $3,000 dollar sheets.

The real ratio people need to be focused on is debt service ratio, meaning how much income we allocate towards the servicing of our debts (payments). This is the real stat that economists pay attention to. It just doesn’t sell nearly as many newspapers.

To illustrate, let’s consider a very normal Kelowna scenario; homeowner of a $400,000 home with a $360,000 dollar mortgage on it. This hypothetical Kelowna couple probably makes a combined annual income of approximately $90,000. According to the fear mongering statisticians they’d have a debt coverage of 4:1 or let's say we're trying to sell news papers - Kelowna couple has put themselves 400% beyond the nations safe debt ceiling…will they survive? Hmmm…

Let's run the numbers quickly. Their mortgage payment would be approximately $1700/mo - this equals 20% of their household income. This is approximately half of what their maximum borrowing ability would be based on CMHC guidelines. I’m thinking they’ll be okay. Remember CMHC is the one holding the bag if Canadians default, so they certainly have an interest in keeping Canadians afloat.

REIN Canada shared a stat that as compared with year 2000, Canadians have a lower debt service ratio. They also pointed out that our mortgage default rate has gone down a considerable amount too. Imagine that, the important stats say we’re in better shape now than year 2000? Interesting…

So let's say for a minute I’ve managed to temporarily neutralize the effects of this month’s news headline long enough for you to take an innocent peak at the wonders of applying leverage to your portfolio.

An investor is eyeing a side by side duplex for $400,000. It’s attractive because it is renting for $1500 per side or $3,000 per month. The CAP rate is strong, almost 9%. So does the investor pay cash and receive after property taxes and maintenance, a return of 6-7% per year on his money? Or….

Put 20% down ($80,000). Carry a $320,000 mortgage ($1327.28/mo), leaving net operating income at $20,072.64 per year. Less the same expenses I used for the example above leaves a net of $15,072 on an investment of $80,000. That’s 18.8%, which is almost triple the return of the unlevered. But wait, there’s more! What about the fact that the tenants have been paying down the mortgage? In one year they’ve increased his equity by nearly $7,000. That on its own is 8.75% ROI. Combine the benefits of positive cash flow and mortgage reduction, the leveraged investor is raking in 27.3% on his $80,000 investment.

And there’s even more to the story! This investor still has $320,000 dollars of the 400k he contemplated placing in the duplex. What ever will he do with that, another duplex or two perhaps? Let's just say he wants to play it safe and put the remainder into a blended real estate fund offering 8-10% known as a REIT. Now he’s making approximately $30,000 in dividends from that investment too. Is this making sense?

I’m thrilled to share that Kelowna residents have decided that it's time to come up from the bomb shelter and take whatever money they survived the recession with and put it to work again. Since this time last year we have seen a steady increase month over month in the percentage of real estate transactions that were purchased for investment. This is encouraging not just for the economy but for my firm specifically as we have carved out a niche in the Kelowna market as Real Estate Investment Advisors.

Recently clients have come to us looking to make a real estate investment, well done! Great choice! However many have been adamant that they pay cash for the property. Try as I might to explain the benefits of all time low interest rates and the powerful effects of leverage on their ROI, still they choose to stay away from this scary debt monster. My job is to educate and inform however, I fear consumers are far too influenced by the media and don’t make the pragmatic decision to learn how leverage works. I hope this helps a few.

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About the Author

AJ is the owner of Kelowna’s downtown boutique firm, Vantage West Realty. The firm takes pride in breaking the mould when it comes to how they practice real estate. With a well-deserved reputation as a real estate renegade, Hazzi has been shaking up the Kelowna real estate scene since 2002.

Having been a student of real estate through two market cycles, AJ has come to see an absence of truly qualified professionals specializing in investment real estate. This has become AJ’s role within the firm and the community: To educate clients on how to achieve financial freedom through real estate.

Arming his clients with knowledge on where to find positive cash-flow, how to renovate for profit, and other creative avenues that most agents completely ignore, Hazzi has carved out his niche as a real estate investment advisor (REIA), and loves nothing more than educating people on the right strategy to capitalize on both boom and bust years.  AJ is a firm believer that the Kelowna market is rich with opportunity, if one knows where to look.

If you are in search of an advisor who practices what they preach, consider that AJ has built his own real estate portfolio up to include multi and single family cash-flow rental properties, development property, resort property, fix and flips, and commercial properties. By sharing the lessons learned from his own experiences, his clients get the knowledge and confidence to invest without having to make the expensive mistakes he and many new investors have made along the way.

His goal is to impart on people, especially of the X and Y generation, that depending on RRSPs and Government Pension Plans to look after us down the road is risky business. Most people don't realize that as little as one or two properties added to your real estate portfolio now, can secure a comfortable, even lavish, retirement.

Bringing a consultant's approach rather than the tired, old-fashioned sales approach, AJ and his partners offer a world class service from finding, pre analyzing, and negotiating your next acquisition, to property management, all tailored to today’s busy investor.

To hear what AJ Hazzi's clients have to say about his service view the testimonials.

Contact Information

For more details or to reach AJ Hazzi, please visit www.vantagewestrealty.com

Email [email protected] Cell 250.864.6433

The views expressed are strictly those of the author and not necessarily those of Castanet. Castanet does not warrant the contents.

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