5 ways to reduce the risk associated with leveraging real estate multi-housing

“Beware of just shopping for interest rates or down payment percentages! It can be a dangerous game. “

Multi-unit real estate investing is gaining popularity thanks, in large part, to the possibility of using “leverage”. Being the one who introduced multi-housing financial engineering to the Quebec market, it is natural for me to be the first to encourage its use. It is also very common, in multi-housing real estate training, to teach how to maximize this leverage effect through “creative” financing. However, it is important to use good judgment when using this technique. Indeed, if its use is the fastest way to massively create wealth, it is also the fastest way to lose a lot of money!

Definition

Leverage involves borrowing money to buy a building with the goal of earning a higher ratio than the cost of borrowing. The profits obtained thanks to the debt thus become more important than the value of the indebtedness.

For example, it is often mistakenly believed that the interest rate is the most important aspect of a mortgage. A skilled investor understands that depending on their profile and strategy, other factors are just as important if not more:

  • the debt coverage ratio (DCR);
  • the loan-to-value ratio (PVR), the term;
  • the qualification rate;
  • the necessary net worth and the bond;
  • amortization.

Choose your mortgage smartly

I see you grimace as I read. You believe that the less interest you pay, the more money you put into your pockets. Yes, that’s not wrong. By cons, with this logic you think in the short term and you neglect the potential risks when refinancing!

For example, let’s take a CMHC multi-unit mortgage for a $ 660,000 6-unit home that generates $ 50,000 in Year 1 and $ 54,500 in Year 5, where EV of the building is equal to the price paid, the loan granted will then be 85%. This represents a loan of $ 517,000.

In year 1, the DCR used to establish the economic value (EV) is only 1.10, that is, for each dollar of the monthly cost of the mortgage, the building will have to generate 1, $ 10 after all standard operating expenses. On the other hand, when refinancing in 5 years, the RCD requested by CMHC will be 1.20.

At the end of the term, the mortgage balance will be $ 483,000. 5 years later, applying a DCR to the refinancing of 1.20, the new loan will be $ 511,000. There will remain $ 28,000 to use for the purchase of a new property. Until then, all is well in the best of all worlds.

Now, let’s apply risk management assuming that the interest rate has increased by 1%. DISASTER! The new loan will be only $ 452,000! This is when the bank will ask to pay a new down payment to make up the difference between the remaining balance of the initial mortgage and the refinancing. It will therefore pay $ 31,000 from his pockets to keep a building bought 5 years ago, in addition to having lost the capitalization of the first 5 years.

scenarios

Stable interest rate

Financing loan $ 517,000

Balance at term $ 483,000

Refinancing Loan $ 511,000

Available money $ 28,000

Interest rate +1%

Fining loan $ 517,000

Balance at term $ 483,000

Refinancing Loan $ 452,000

Available money-$ 31,000

 

Do you understand me better now? Here are 5 ways to reduce the risk associated with leverage that you can apply right now!

  1. Model the economic values at the end of your first mortgage

The above example leads us to the first way to reduce the risk: estimate the EV at the end of the mortgage. It is not sufficient to establish the current EVs before buying a block. Future EVs must also be calculated. This is modeling, and for those who are not able to do it themselves, believe me, the next decade in multi-housing real estate will be cruel to them.

Definition

The economic value (EV) is calculated according to the maximum loan that the building can afford, satisfying all the conservative criteria of the bank:

  • Revenues reduced by the vacancy rate for the sector, plus 1% to 2%;
  • Actual expenses + management and concierge fees as if the building were managed by a third party;
  • Qualification rate;
  • RCD;
  • TGA of comparable properties in the sector.
  1. Evaluate the possibility of taking a 10-year term

One of the simplest ways to reduce the risk associated with refinancing is to take a longer term. In Quebec, we mainly take 5 year terms. It’s fashionable, I guess. Yet, in the United States, most of my clients take 10-year terms. The wealthiest investors also take 10 year terms. In the example mentioned above, a 10-year term would effectively avoid the unfortunate consequences of the increase in the mortgage rate.

  1. Active management of your wallet

At MREX College, in our courses and in our mentoring program La Meute multi-logements, we are constantly telling our students that the financial analysis of buildings is not just about buying, but also every year, even every quarter. Actively managing your property portfolio is one of the best ways to predict risky situations. This allows you to make the necessary adjustments, either by increasing rents, saving, or finding financial partners at the right time, in a planned, efficient and profitable way.

  1. Provident fund

Having a contingency fund composed in part of the cash flows of your building and your own monthly savings is an excellent way to reduce risk in relation to leverage. If the acquisition of a building does not create such a fund, it does not correspond to your investor profile.

  1. Partnership

The last method is to associate. To two investors: the risk is divided, the purchasing power increases and the financing and refinancing conditions are better. Indeed, the risk for the bank is reduced since there are: 2 net values, 2 and and 2 people to endorse in solidarity.

Finally, because the past 20 years have been so successful, if not easy, few investors understand the reality of today’s market. In fact, risk is increasingly present in the multi-housing market as interest rates rise. Is this a reason to stop investing in real estate? No! Is this a reason for using less leverage? Not necessarily. One thing is certain, we need to become skilled investors, much more than the previous generation of homeowners.

This is an adaptation of my article originally published in the magazine Les Mordus d’Immobilier: “6 ways to reduce the risk associated with leveraging real estate multi-housing”

These are very important points for someone purchasing multi- unit properties. However there are times when you need a Private Lender that specializes in apartment buildings to give you a loan for a period of time and one of the top private lenders in Montreal is Tempbridge Inc. Visit them at www.tempbridge.ca and see what they can do for you.