How investors are using leverage to grow their portfolio
It’s no secret that the Canadian real estate market has built wealth for many investors in recent times. However with mortgage rates on the rise and property values sky high, it can seem almost impossible to afford a single property, let alone a portfolio of them.
We’ve discussed in previous articles the benefits of using leverage to grow your portfolio, and how your home can be a valuable way for you to access cost-effective financing. In this article let’s take a look at how some investors have been continually growing their real estate portfolio, utilizing leverage to acquire multiple properties.
Recommended reading: How to leverage your home to diversify your portfolio
You may have heard of something called the “BRRR method” online or in the news, and it’s a relatively simple concept to get your head around. At the same time there are a number of risks associated with the strategy, especially if you aren’t knowledgeable about using leverage effectively.
What is leveraged investing?
For a full introduction to leveraged investing and how it works, check out our article “An introductory guide to leveraged investing”.
How do investors use leverage to grow their real estate portfolio?
While “using leverage” might sound like something that only the seasoned investors among us do, most Canadians already use leverage to purchase real estate: with their mortgage!
A mortgage is one the most common form of leverage that investors use to grow their portfolio. Typically when you purchase a property you might put down 20% in cash to build equity while borrowing the remaining 80%. If you’ve then increased that equity over time by paying off the mortgage, it’s likely that the cheapest leverage you have access to would come in the form of borrowing against the equity in your existing property.
For a great example of leverage in action check out this write-up by our Head of Mortgage Advisory, Ali Hussin: HELOCs in action: Maximizing cash flow.
What is the BRR method?
The “BRRR method” refers to a recently popularized strategy of purchasing property and then borrowing against the equity of previous properties to fund the purchase of more rental units.
An investor using the “BRRR method” would purchase a rental property, start generating income from it to pay for the mortgage, and then shortly after, maybe a year or two later, access financing by borrowing against the equity in the property to fund the down payment of their next investment property.
This method of continually purchasing properties by accessing leverage through the previous ones has been used to quickly accumulate multiple investment properties by some investors, however if things go awry, the consequences of being over-leveraged could be disastrous.
The problem with the “BRRR method”
While there’s no doubt real estate has been profitable for many investors and the “BRRR method” has gained traction due to its success in the short term, the potential consequences of not fully calculating the risks associated could be devastating.
The “BRRR method” relies on generating enough income from your rental properties to pay for the mortgage of future properties, but in the event of a market downturn your losses could add up fast. If rental rates were to fall you could be left owing more in mortgage payments than you have income to pay with, forcing you to liquidate assets. If the value of homes goes down a significant amount you’ll be left underwater on your mortgages, and if you’re forced to sell, you could be left owing way more than you have the capital to afford. Over-leveraging with the “BRRR method” could be a fast-track to bankruptcy if you don’t carefully plan your strategy and don’t over-leverage yourself beyond what you can afford if things go wrong.
The risks of over-leveraging
Utilizing leverage can be a tempting way to increase potential returns in your portfolio, but it’s critical to understand the risk involved with using leverage in the wrong way. While using leverage to invest in risk-free assets like GICs could mathematically make sense, when you introduce volatility into the mix it’s a whole different story.
The primary danger with leverage is the event that your investments yield less than the cost of borrowing and you end up needing to pay interest without any profit to do so. That is why it is critical when investing in assets like real estate with leverage to ensure that even in the worst case scenario you will still be able to pay off the balance of the loan. If you’ve borrowed more than you can afford to repay in the event your investments don’t turn out as planned, you could be in a lot of trouble.
Here are some of the risks associated with over-leveraging your portfolio:
- Magnified losses: If your leveraged investments depreciate and you need to sell them due to your financial situation, you’ll still need to pay off the loan with interest, meaning you’ve lost more than you would have investing in the asset with non-borrowed capital. In the worst case scenario you may have to liquidate your other assets to pay for the loss.
- Poor cash flow: If you’re investing in assets which don’t generate more income than the interest payments of the loan, you’ll end up with worse cash flow than you would have otherwise. You could be left paying interest on the borrowed capital without income to offset it.
- Maturity risk: Depending on the conditions of your loan, your lender may demand early repayment under specific circumstances. If this happens during a time when your investments are down, you may need to sell at the wrong time and realize losses that could have been avoided.
Alternatives to grow your portfolio
While the “BRR method” focuses on using massive amounts of leverage to rapidly grow a portfolio of rental properties, there are of course many other ways you can use leverage to reach your financial goals. Rather than borrowing equity from your property to invest in more real estate, you might want to consider using something like a HELOC to diversify your portfolio.
Generally it’s a good idea to use leverage when the returns from an investment are expected to be more than the cost of borrowing capital. If you can borrow equity from your home at 4.00% annual interest to invest in a guaranteed 5.00% returning GIC, it could be a good idea to do so.
As previously discussed, the biggest risk of leverage comes with investments with high volatility which could potentially leave you paying more interest than you can handle to hold on to your depreciated assets. With this in mind when looking at ways to use leverage in your portfolio you might want to consider less volatile, income generating asssets. Bonds, dividend funds, real estate, and mortgage funds are all examples of income generating assets, with potentially less risk premium when compared to other assets like equities.
Perch Capital for example is one such mortgage fund which offers a target 9% annual return rate and could potentially represent a great opportunity for an investor to acquire an income generating asset while still having exposure to the Canadian real estate market.
Safely utilizing leverage to grow your portfolio
Let’s imagine you’re nearing retirement with a paid-off home valued at $1,000,000. You talk to your mortgage advisor and find out you qualify for a HELOC of up to $800,000 at 4.50%.
You have enough liquid assets that you can afford to pay some of the interest payments, even if your investments are volatile in the short-term. You’ve heard of a mortgage investment fund that is advertising 9.00% returns with a minimum investment of $50,000. You decide to borrow $500,000 in the form of a HELOC, invest in the mortgage investment fund and net around $22,500 annually. You’ve now leveraged your home equity to generate passive income with minimal effort and lower risk than a volatile asset like equities.
This article should not be taken as legal, tax or investment advice. Please consult your wealth advisor, tax professional and legal professionals to confirm if leveraged investing is right for you