We recently presented our Rent to Own program to a group of real estate professionals. During the question period afterwards, one of the Realtors wanted to explore the investor side of our deals. When he learned about the strong returns he exclaimed, “Great returns and it’s secured by real estate – that’s fantastic! How do you get those returns?” The answer is simple: Leverage.
The secret ingredient to the success of investing in real estate – beyond the first law of location – is the concept of leverage. What do I mean by leverage? Simply put, I’m referring to the fact that you are making a return on the bank’s money.
Here’s how it works: Let’s say you’re buying a property for $200,000 and you’d like a conventional mortgage so you decide to put 20% as a down payment. In this case, that would mean that you would provide $40,000 plus closing costs towards the purchase of the house. Lenders typically use a multiplier of 1.5% of the purchase price to calculate the closing costs so for this illustration we’ll do the same. In this example, your closing costs would therefore be $3,000 (i.e. $200,000 x 1.5%). In total, you would spend $43,000. The bank would then lend you $160,000.
Now let’s assume that your property appreciates 3% in the first year. This means that at the end of the year the house would be worth $206,000. For you however, that represents much more than a 3% increase; in fact it’s a gain of 13.95%. Why? Because you didn’t spend $200,000 to buy the house, you spent $43,000. To calculate your Return on Investment (ROI) you take the gain (i.e. $6,000), divide it by the total amount of money spent ($43,000) and multiply by 100 to get a percentage. It’s true that you paid interest in that time which added to the cost but you also paid off some principal and therefore you benefit from the mortgage pay down. Even if we shave off some profit because of the interest paid, you’re still looking at a double digit Return On Investment. In short, you are making a return not only on the money you provided for the deal but also on the bank’s share. That is the power of leverage.
Stocks and mutual funds
Now let’s compare this to stocks or mutual funds. In the latter cases you pay 100% of the cost to purchase the funds and your returns are calculated on the full investment amount. If your fund had gone up by 3% then your ROI would be 3%; there is no leverage at play here unless you borrow the money for the funds. If you are using borrowed money to buy stocks or mutual funds, you are praying that the stock goes up sufficiently to cover the cost of borrowing and provides a reasonable return over and above that. Take a look at your investment portfolio and consider how many stocks and mutual funds would have met that criterion.
You may object by saying that real estate also goes down in value at times. That’s true, however if you have picked a market that is stable you probably won’t face too many negative value swings. Ottawa, for example, is a great place to invest precisely for that reason: It is stable and mostly predictable. In the last 50 years there have only been a handful of years in which values went down on average and most of those occurred during the technology crash of the 1990s. Pick virtually any area of Ottawa today and you will find nice, steady growth despite worldwide economic challenges. Ottawa will never win any awards for growth and frankly that makes it an ideal place to invest! Slow and steady definitely wins this race.
Back to the Realtor’s question: Yes it is possible to have strong returns in a rent to own deal and yes those investments are backed by real estate in a strong, stable city. Strong returns can occur while ensuring that the deals are fair and balanced for everyone involved, particularly the tenant buyers.
Look for realistic purchase prices, especially the buy-out price if you’re considering a Rent to Own deal; insist on reasonable cash flow that does not take advantage of the clients; and finish it up with professional documentation and a solid plan for execution.
Then enjoy the power of leverage!