CALCULATING THE RISK AND REWARDS OF LEVERAGE IN REAL ESTATE INVESTMENT

Are you thinking about investing in property but don't have enough money to buy it outright? You're not alone. Many successful property investors started by using what we call "leverage" - simply put, using loans to buy property. But, how do you balance the potential benefits with the inherent risks?

Let's break this down in a way that makes sense for you.

WHAT IS LEVERAGE IN REAL ESTATE INVESTMENT?

Leverage involves using borrowed capital to finance a portion of your real estate investment. Instead of waiting 10 years to save ?50 million to buy a property, you could start with ?15 million as down payment and get a bank loan for the remaining ?35 million. This is what we call leverage.

Read more here on what leverage means here

WHAT ARE THE BENEFITS OF USING LEVERAGE TO FINANCE YOUR REAL ESTATE INVESTMENT?

1. Increased Purchasing Power

Borrowed funds enable you to acquire more properties or higher-value assets. Instead of waiting many years to save up, you can own property now and start making money from it.

You could start with a cozy apartment in Epe, a prime shop in Ikoyi, land in up-and-coming areas like Asaba, or a lucrative shortlet apartments in Ikoyi.

2. Potential for Higher Returns

Leverage amplifies rental income and appreciation, making your money work harder for you.

With 50 million naira in savings, you could make three down payments of 15 million naira each, control three properties worth 50 million naira each, and potentially earn rent from all three.

3. Tax Benefits

Did you know interest on borrowed funds may be tax-deductible? Interest payments on your loan reduce your tax liability, property depreciation gives you tax advantages, and rental income helps pay off your loan.

Example:

Suppose you invest 50 million naira in three properties with a 20% down payment (10 million naira each) and a 40 million naira loan. Potential rental income is 3.6 million naira per year (1.2 million naira per property), appreciation is 10% per year (5 million naira per year), and tax benefits include reduced tax liability on interest payments.

WHAT ARE THE RISK OF USING LEVERAGE TO FINANCE YOUR REAL ESTATE INVESTMENT?

1. Debt Servicing

When you take out a loan to buy a house or a land, you will need to make regular interest payments, which can put a strain on your Cash Flow. It’s like having to pay ?500,000 every month for a ?50 million loan. If your rental income or other sources of funds aren't sufficient, you might struggle to keep up with payments.

2. Default Risk

If you fail to repay the loan, the lender can take possession of the property through foreclosure. This can be devastating, especially if you have invested a significant amount of your own money. For instance, if you default on a ?50 million loan for a property, you might lose the property and damage your credit score. But this depends solely on the agreement between the lender and the borrower.

UNDERSTANDING DIFFERENT DEBTS LEVELS

We use something called the debt-to-equity ratio to know if we are borrowing too much.?

WHAT IS DEBT-TO-EQUITY RATIO?

The Debt-to-Equity Ratio (D/E) is a financial metric that compares a company's or individual's total debt to its total equity.

Debt-to-Equity Ratio Formula:

D/E = Total Debt / Total Equity

An ideal debt-to-equity ratio in real estate is 2.33 meaning you have 70% debt and 30% equity.

Here's what debt-equity ratio means in simple terms:

If you own a ?50 million property and:

- You borrowed ?35 million (loan)

- You paid ?15 million (your money)

Your debt-to-equity ratio is 2.3:1 (?35 million ÷ ?15 million)

A SIMPLE GUIDE TO BORROWING.

- SAFE: Borrowing the same as your money (1:1)

- NORMAL: Borrowing twice your money (2:1)

- RISKY: Borrowing three times your money (3:1)

- VERY RISKY: Borrowing four times or more (4:1)

UNDERSTANDING RISK-REWARD RATIO

The Risk-Reward Ratio (RRR) is a metric that compares the potential return on investment (ROI) to the potential risk of loss.

Risk-Reward Ratio Formula:

RRR = (Potential Return / Potential Risk)

The ideal risk-reward ratio is 1.5:1

Example: RRR = (Expected Return: ?150,000 / Expected Loss: ?100,000) = 1.5:1

CALCULATING THE RISK-REWARD RATIO IN REAL ESTATE

To make informed decisions, the following metrics:L must be considered:

1. Debt-Service Coverage Ratio (DSCR)

Calculate the property's net operating income (NOI) divided by annual debt service.

2. Loan-to-Value (LTV) Ratio

Ensure the loan amount doesn't exceed 80% of the property's value.

3. Cash-on-Cash Return

Calculate the annual cash flow divided by the total cash invested.

4. Cap Rate

Measure the property's net operating income divided by its value.

What are the Best Practices for Leveraged Investment

1. Conduct thorough market research

2. Monitor cash flow and debt service

3. Maintain an emergency fund

4. Set realistic expectations

5. Diversify your portfolio

EXAMPLE:?

Assume you are investing in a ?20 million property with a 20% down payment (?4 million) and a ?16 million loan at 12% interest.

Now, let’s break down the calculation for the Risk-Reward Ratio:

Investment Details:

- Property Value: ?31.25 million

- Purchase Price: ?20 million (assuming ?11.25 million discount)

- Down Payment: ?4 million (20%)

- Loan: ?16 million (80%)

- Interest Rate: 12%

Below are the Key Metrics:

1. Debt Service Coverage Ratio (DSCR): 1.25

????- Net Operating Income (NOI): ?2.5 million

????- Annual Debt Service: ?2 million

2. Loan-to-Value (LTV) Ratio: 80%

3. Cash-on-Cash Return: 15%

????- Annual Cash Flow: ?1.2 million

????- Total Cash Invested: ?4 million

4. Capitalization (Cap) Rate: 8%

????- NOI: ?2.5 million

????- Property Value: ?31.25 million

The calculation is as follows

Potential Reward:

- Annual Cash Flow: ?1.2 million

- Potential Appreciation: assume 10% annual growth (?3.125 million)

Total Potential Reward: ?4.325 million

Potential Risk:

- Loan Default Risk: assume 10% probability of default

- Potential Loss: ?16 million loan + ?4 million equity = ?20 million

- Mitigated by DSCR > 1 and LTV < 100%

Total Potential Risk: ?2 million (10% of ?20 million)

The RRR becomes:

RRR = Total Potential Reward / Total Potential Risk

RRR = ?4.325 million / ?2 million

RRR = 2.16

The Risk-Reward Ratio of 2.16 indicates that for every ?1 of potential risk, there's a potential reward of ?2.16. This suggests a favorable investment opportunity.

THINGS TO CONSIDER WHEN CONSIDERING THIS CALCULATION:

1. Market volatility
2. Interest rate fluctuations
3. Tenant vacancy risks
4. Maintenance and property management costs

By carefully evaluating these metrics and considering the risks and rewards, you can make informed decisions about leveraging financing for your real estate investments.

CONCLUSION

Leverage can be a powerful tool in real estate investing, but it requires careful calculation and risk management. By understanding the benefits and drawbacks, you can navigate the complex world of leveraged investing and grow your portfolio with confidence.

At Jglobalproperties, our experienced team is dedicated to helping you understand the real estate market. Contact us today to discuss your investment goals and create a personalized strategy.

Best Regards,

Joan Obi-Okuhon,

Real Estate Advisor.