Building a portfolio is a bit like engineering a bridge. If you aim to reach the other side of the valley, you could just fill it with rocks. That would probably make for a pretty solid ‘bridge’ but not the most efficient use of material.
Alternatively, you could design and build a bridge. You can build the bridge to any spec you choose. It could be a footbridge. It could be built to carry 100 tanks at once. It could be designed to weather a tornado or earthquake. Whatever your specifications, you can use physics and engineering knowledge to determine the minimum amount of material needed to achieve that spec.
If our portfolio is the bridge, the material used to build the portfolio is capital. We want to make efficient use of our building materials. If you can safely build your bridge with 50% less material, you get 2x as many cars crossing that valley for every dollar spent.
For example, let’s say you buy a building for $1 Million cash that generates $80k in net profits per year. Over 5 years, you net $400k and then you sell the property for $1.2 Million. You’ve profited $600k, which equates to a 60% return.
What if you had financed the purchase with a $800k mortgage? You still earn $600k as above but over the 5 year period you’ve paid $150k in interest to the bank. But your down payment was only $200k. Now you’ve earned $450k ($600k – $150k) on $200k invested instead of $1 Million. This equates to a 225% return.
So leverage has its place. In many markets, you can safely build a portfolio using just 1/4 of the capital you would need to buy the properties cash.
Leverage can also kick you in the rear. Here’s the thing. Leverage requires debt-servicing. On an $800k mortgage, payments will be about $50k annually. Of this, $30k will be interest and $20k will be paid down on your mortgage principal – all of which eats into your cashflow.
As we’ve discussed in previous articles, the key principal of a resilient portfolio is that each property should carry its own weight. In other words, the property’s income should exceed all of its operational costs and debt-servicing. Any excess cashflow is your buffer against market volatility.
If your property is overleveraged, your incomes may not cover your costs. This means your cashflow will be negative and you will be forced to pay money out of pocket in order to service your debt. That’s all well and good if you have an overleveraged condo that costs you $100 a month. But if your whole portfolio is overleveraged, are your pockets going to be deep enough to keep your portfolio propped up?
When pockets run dry, the portfolio will eventually collapse under the weight of its debt obligations. Mortgage payments are missed. Creditors take the asset and sell it to get their money back. And the portfolio owner gets to keep whatever is left over, if anything, after everyone else has been paid.
This is the most common risk that impacts real estate owners.
In a well-engineered portfolio, each property is sufficiently capitalized so that its cashflow can easily service its debt. Leverage must be counter-balanced by cashflow. We want to use our capital efficiently. But there will be storms that affect vacancy rates, rents, interest rates, etc. If the weather gets out of hand, our cashflow buffer will make the mortgage payments. And if the weather is mild, we get to convert our cashflow buffer into dividends.
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