Real Estate Investing – Cash Flow Leveraging
Cash flow leveraging is about how borrowing can impact your cash coming from your rental properties.
The first important thing to understand in cash flow leveraging is the capitalization rate. It is important to know how much the property is paying you. In its simplest form capitalization rate is the net rental income from the property divided by the purchase price.
Let us say you buy a property for $100,000. Let us assume gross income from this property is $14,000. Total expenses that include rates, insurance, maintenance & management come to $4,000. The net income from the property will be $10,000 ($14,000 minus $4,000). The net yield or cap rate on the property will be $10,000 (net rent) divided by $100,000 (purchase price) or 10% in this case.
The next important thing to understand in cash flow leveraging is the cost of borrowing funds. It is not a simple case of interest on your loans but must also into account the amortization cost and the loan period to work out the loan constant. Let us say that the cost of borrowing is 7%.
The difference between the cost of borrowing and the return from your investment property is called the spread. In our example above we have borrowed money at 7% and are getting a net return of 10%. In this case we have a positive leverage on the property.
If the return from property was lower than the cost of borrowing we will have a negative leverage. A neutral leverage will occur when the cost of borrowing is same as return from the property.
When you are buying a property for cash flow you have to purchase only positively leveraged property. If you do this the cash flow leverage will work in your favor.
Investors sometimes buy negatively or neutrally leveraged property in the hope that capital appreciation from the property will overcome the short term cash losses on the investment. In this case you will need to support the short fall in cash flow from other sources of income. This can become very worrisome if the investor loses his job or suffers losses in his business that is supporting the negatively leveraged property.
A positively leveraged property can turn into a negative leveraged property in case of loss of rental income or if the interest rates move up at the time of re-fixing the mortgage. It is therefore prudent for you to allow for the vacancy rates or changes in the cost of borrowing.
No one can allow for all the contingencies that may occur in the future. But if you can work out your figures accurately for the first five years then chances of things going wrong with your investment are greatly reduced. This is because rents will normally go up to provide you with additional cash flow. In addition increase in capital value of the property will give you with an extra cushion of equity.
A negatively leveraged property will move into positive territory given time and a few rent reviews along the way.
As an investor you will keep out of trouble if you apply cash flow leverage properly and make it a habit of buying only positively leveraged properties. This is what Robert Kiyosaki and all savvy investors do. You must always concentrate on cash flow first and capital appreciation later.
Investing in residential properties is the best strategy when starting out as a real estate investor. The biggest leverage you can have in the process of creation of wealth through real estate is knowledge.
By Robert Benson