- Joined
- Aug 30, 2007
- Messages
- 13,881
Leverage is a two edged sword. It works well if the yield (or CAP rate) of a property is higher than the interest rate.
It works especially well if the markets goes up.
It does not work so well if interest rates are on the rise, and thus yield expectations rise and thus, property values potentially fall with lower or even flat income.
When are you too levered ?
Mortgages are usually set for a 5 year term in Canada. Expect 5 years rates to nudge up gradually over the next few years .. from a current high 3% range to 6% or so in 3-4 years ! 6% is what you pay TODAY for commercial non-CMHC money and that will likely go to 7.5 or 8% in 3-4 years .. with higher bond rates but lower spreads !! (spread being the premium the lender charges over their cost of money, which is the 5 year bond)
==> Hence: analyze any deal @ 6% with 25 year amortization .. and stress test with an 8% mortgage. You are too levered if it does not cash-flow at this level.
A highly levered deal at 4% interest rate is risky and works only if proven rental upside is there so that in 5 years you don't say "oops" or hand the property keys to the bank !!
If the property cash-flows at a 90% LTV with a 3.5% mortgage .. great .. but test it with 6% and 8% anyway .. especially if you take a very risky 30 or 35 year amortization as the risk in 5 years is quite high ! Then assess what you would do in 5 years if market is fairly flat and rates are at 6% and your mortgage is not substantially lower than at the start !
With a 25 year amortization you pay the mortgage down 10% in 5 years, so if you are levered at 80% going in you'll have a more comfortable 72% LTV in 5 years if values don't go up in 5 years .. or around 65% if values go up 10% in 5 years. This is our risk tolerance level, with the right blend of great ROI and sleeping well at night.
A related post on ROI based on leverage using certain yield assumptions is here:
http://myreinspace.com/public_forums1/Real_Estate_Discussion/62-10711-Equity_is_not_the_only_way_to_make_money_in_real_estate.html
Those are my thoughts .. what are yours ?
It works especially well if the markets goes up.
It does not work so well if interest rates are on the rise, and thus yield expectations rise and thus, property values potentially fall with lower or even flat income.
When are you too levered ?
Mortgages are usually set for a 5 year term in Canada. Expect 5 years rates to nudge up gradually over the next few years .. from a current high 3% range to 6% or so in 3-4 years ! 6% is what you pay TODAY for commercial non-CMHC money and that will likely go to 7.5 or 8% in 3-4 years .. with higher bond rates but lower spreads !! (spread being the premium the lender charges over their cost of money, which is the 5 year bond)
==> Hence: analyze any deal @ 6% with 25 year amortization .. and stress test with an 8% mortgage. You are too levered if it does not cash-flow at this level.
A highly levered deal at 4% interest rate is risky and works only if proven rental upside is there so that in 5 years you don't say "oops" or hand the property keys to the bank !!
If the property cash-flows at a 90% LTV with a 3.5% mortgage .. great .. but test it with 6% and 8% anyway .. especially if you take a very risky 30 or 35 year amortization as the risk in 5 years is quite high ! Then assess what you would do in 5 years if market is fairly flat and rates are at 6% and your mortgage is not substantially lower than at the start !
With a 25 year amortization you pay the mortgage down 10% in 5 years, so if you are levered at 80% going in you'll have a more comfortable 72% LTV in 5 years if values don't go up in 5 years .. or around 65% if values go up 10% in 5 years. This is our risk tolerance level, with the right blend of great ROI and sleeping well at night.
A related post on ROI based on leverage using certain yield assumptions is here:
http://myreinspace.com/public_forums1/Real_Estate_Discussion/62-10711-Equity_is_not_the_only_way_to_make_money_in_real_estate.html
Those are my thoughts .. what are yours ?