Definition<\/strong><\/p>Leverage consists in borrowing money to buy a building, so it produces greater return than what the loan cost itself. Therefore, the profits made through debt become greater than the debt value. For instance, according to a common misconception, interest rate would be the most important part of a mortgage. However, a skillful investor knows that, depending on his profile and his strategy, other aspects are as just as important, if not more so:<\/p>\n\n\n\n As you read through this text, I imagine you frown. You think the less interest you pay the more money you put into your pockets. Well, you\u2019re not completely wrong. However, according to this mindset you engage in short-term thinking and you overlook the possible refinancing risks.<\/p>\n\n\n\n Let\u2019s consider the example of a CMHC-insured multifamily loan, for a 6-unit building, purchased $609,000. It generates $50,000 of income the first year and $54,000 the fifth year. The building\u2019s economic value (EV) is equivalent to the amount paid and the granted loan will be $517,000, i.e. 85%.<\/p>\n\n\n\n The first year, the DCR used to establish the EV is only 1.10. That\u2019s to say, for each dollar of the mortgage monthly cost, the building should generate $1.10 after standardizing all expenditures. On the other hand, five years later at the time of refinancing, the CMHC will require a DCR of 1.20.<\/p>\n\n\n\n At the end of the term, there will be a $483,000 mortgage balance. When refinancing five years later, with a 1.20 DCR, the amount of the new loan will be $511,000. Also, you have $28,000 to buy a new property. So far so good!<\/p>\n\n\n\n Now, let\u2019s apply risk management on the assumption that the interest rate has increased by 1%. DISASTER! The amount of the new loan is only $452,000! Consequently, the bank will require a new down payment to compensate for the difference between the first mortgage balance and the refinancing. Therefore, you would have to pay $31,000 from your pockets to keep a building purchased five years ago, without counting the first five years\u2019 loss of capitalization.<\/p>\n\n\n\n Now, do you see better what I mean? Here are 5 ways to reduce risks associated to leverage that you can already apply!<\/p>\n\n\n\n The above example brings us to the first way to reduce risks: assess the EV at the end of the mortgage term. In fact, it\u2019s insufficient to establish the current EV before buying a building. You should also calculate the potential future EV. This is modelling and for those who cannot do so by themselves, will find the next decade in multifamily real estate really harsh, believe me!<\/p>\n\n\n\n Definition<\/strong><\/p>EV are calculated according to the maximum loan a building can take out, while satisfying the bank conservative criteria. Every building will have its own EV depending on the banking institution and its economic parameters: <\/p>\n\n\n\n One of the easiest ways to reduce risk associated to refinancing is to consider a longer term. In Quebec, people take, generally, a 5-year term; I suppose it\u2019s a trend. However, in the United States, most of my clients choose a 10-year term and so do the wealthiest investors too. In the above example, a 10-year term would prevent adverse consequences due to the mortgage interest rate increase.<\/p>\n\n\n\n At the MREX College, in our classes and program \u201cLa meute multilogements,\u201d we constantly repeat to our students that they shouldn\u2019t realize the building\u2019s financial analysis only on purchase. Actually, they should do it each year, even every trimester. The best way to anticipate risky situations is to manage your real estate portfolio actively. Therefore, it allows necessary adjustments to be made like: increasing the rent, saving money, finding new financial partners at the right moment in a planned, effective and efficient manner.<\/p>\n\n\n\n An excellent way to reduce risk associated to leverage is to form a contingency fund partly made up of your building\u2019s cash flow and your own monthly savings. In the case a building doesn\u2019t allow you to create such a fund, it means that it doesn\u2019t correspond to your investor profile.<\/p>\n\n\n\n The last way is to join forces, because two investors allow to divide the risk, to increase purchasing power, and to obtain better financing or refinancing conditions. In addition, bank faces a lower risk, because it takes into consideration: 2 net worth, 2 drs and 2 people to provide guarantees jointly.<\/p>\n\n\n\n Finally, since the last two decades have been productive, even easy, just a few investors understand today\u2019s market reality. Indeed, we face a growing risk in the multifamily real estate market because of the interest rates increase. Is it a reason to stop investing in real estate? Not necessarily! Is it a reason to use less leverage? Neither! However, we should become, for sure, skillful investors, more than the latest generation.<\/p>\n","protected":false},"excerpt":{"rendered":" Beware not to just shop around the best interest rates or down payment percentages! It may be a dangerous game!<\/p>\n","protected":false},"author":13,"featured_media":1015,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[16],"tags":[],"class_list":["post-1629","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-article"],"yoast_head":"\n
An investor who buys a building with just 25% down payment uses, consequently, a 75% leverage, also known as loan-to-value ratio.<\/cite><\/blockquote>\n\n\n\nCHOOSE YOUR MORTGAGE CLEVERLY<\/h3>\n\n\n\n
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<\/figure>\n\n\n\n1. MODEL THE EV AT THE END OF YOUR FIRST MORTGAGE TERM<\/h3>\n\n\n\n
Incomes minus the area vacancy rate (CMHC establishes percentages)
Actual expenditures + standardized expenditures (management fees and janitorial service fees, as if the building were being run by a third party, maintenance fees).
Qualifying rates (generally higher than the nominal interest rate)
DCR (the debt coverage ratio represents the link between the normalized net income and the monthly or annual debt cost, also known as debt service, which varies generally between 1.10 and 1.30).
LTV ratio (the loan-to-value ratio represents the maximum amount a banking institution would consider acceptable as leverage. Generally, it\u2019s between 75% and 80% for a conventional loan and 85% for a CMHC-insured loan.)
Amortization, i.e. the number of years on which one calculates the loan repayment (25\u201340 years).<\/cite><\/blockquote>\n\n\n\n2. CONSIDER THE OPTION OF A 10 YEARS TERM<\/h3>\n\n\n\n
3. AN ACTIVE PORTFOLIO MANAGEMENT<\/h3>\n\n\n\n
4. CONTINGENCY FUND<\/h3>\n\n\n\n
5. PARTNERSHIP<\/h3>\n\n\n\n