Many people look at real estate investing as a compelling opportunity to earn passive income and diversify their investment portfolio. But in the back of their mind, they may also be thinking about purchasing their own property—either a home or a condo—if they have lived in an apartment for a long time.
Sometimes, tenants will think that renting means throwing their money away each month, money that could have been used to reimburse their mortgage and build equity. Others will see the opportunity cost of having to tie up a good amount of money as a down payment which could have been invested elsewhere in order to generate a better return.
In reality, it depends primarily on your ability to build leverage, the growth of your business, and your priorities in terms of cash flow and value creation.
The Power of Leverage
One of the things you realize in real estate financial engineering is that the less money you put into a project, the more leverage you use, which has a multiplying effect on your returns. For example, let’s say you want to buy a $300 000 house with a five percent down payment ($15 000). To simplify the equation, let’s forget about transaction expenses, mortgage fees, and temporal impact on money.
Let’s assume that, as a result of the increase in value in your area, the value of your home increases by 10 percent in one year to $330 000. By tying up five percent of the value of your house as a down payment, you would have doubled your money in one year. This would represent a 200 percent return on investment. Plus, this capital gain would be entirely tax-free upon resale.
Although this can be an interesting option, you still need to qualify for an insured loan with your financial institution. Needless to say, with a 95 percent mortgage, the monthly payments will be quite high compared to a traditional loan. Thus, the bank will want to make sure that your debt ratios will be able to support them.
Value Creation or Cash Flow
Let’s clarify what differences there are between value creation and cash flow. The former is buying a property with the understanding that it will grow in value and your net worth or equity will increase drastically over a certain period of time while the latter is “the difference between a property’s income and expenses including debts.
If you are tempted to buy a house or a condo, carrying a 95 percent mortgage can be good to increase your net worth all the while needing a very small down payment, but it is much less efficient in increasing your monthly cash flow. For example, an 800-square-foot condo at $500,000 with a five percent down payment represents monthly mortgage payments of more than $2,000 per month, in addition to all the operating expenses.
In short, even if your net worth increases in the short term, it depletes your daily cash flow. Therefore, you will have to plan your mortgage payments for the next 25 years or sell your house if you want to get rid of these large payments.
It is a reasonable decision to manage housing and real estate investments separately if the access to leverage is difficult. This will allow you to ensure the proper management of your personal daily cash flow or if you live in an area in which properties do not gain much in value.
For example, let’s say you put a down payment in a single-family home that loses value. Not only the financial performance of your down payment will be less than what you could create in value in a project dedicated to generating a return, but it will also unnecessarily deplete your monthly personal cash flow.
Your ability to benefit from high leverage, your objectives in terms of value creation or cash flow, as well as the growth of the values in your sector will play a big role in the financial impact of your decision. There are also other factors, such as being a tenant, that will come to play. Of course, this can be good for a while but it is also normal that one day, you may want to own your home.
“If you’re just getting started and you need somewhere to live, it probably makes much more financial sense to purchase maybe a triplex or a quadruplex or a duplex rather than purchase a house,” says MREX’s CEO Nikolaï Ray. “Even as that gets paid off in a couple of years and gains a little bit of value, your second acquisition should then maybe be a multifamily property with the equity from the first property, then after that buy a house,” he adds.