This article explains financial leverage in real estate; the advantages and disadvantages associated with leverage and finally some tax ramifications if the property owner cashes out the equity.
Real Estate Leverage Principle
Financial leverage is a tool in business where the goal is to earn profit in excess of cost of the respective debt instrument. With real estate, financial leverage is used to purchase property as a landlord using tenant payments to service debt. While serving the debt, the property grows in value and the difference between the fair market value and the mortgage principle is customarily called equity. Here is a simple example:
Marty purchases a three unit apartment building already fully occupied. He agrees to pay $250,000 for the apartment building. Rents are $3,000 per month. Marty borrows money from a bank and agrees to pay $1,250 per month for the principle and interest on a $225,000 loan. In effect Marty pays $25,000 out of his pocket to buy the building.
Over a course of five years Marty pays $7,000 of principle on the note and the real estate market grows at 2.1% per year. How much value (equity) does Marty earn using leverage?
To solve this problem, first determine the fair market value of the building after five years.
Year 0 $250,000 $250,000
Year 1 2.1% Growth 255,250
Year 2 2.1% Growth 260,610
Year 3 2.1% Growth 266,083
Year 4 2.1% Growth 271,670
Year 5 2.1% Growth 277,376
Marty’s equity position is simply the fair market value less principle portion of debt.
Equity: FMV minus Principle of Debt
Equity = $277,376 ($225,000 original amount borrowed less principle paid)
Equity = $277,376 – $218,000
Equity = $59,376
Remember of the $59,376; $25,000 is Marty’s original investment. Marty’s return on his $25,000 is $34,376. This is a 19% per year return on investment.
If the growth rate for real estate were 3.5% the building’s fair market value in year five is $296,922. Equity equals $78,922 and Marty’s return on investment is now $53,922 or almost 26% per year. A simple 1.4% change in market growth on the entire $250,000 investment generates an additional 7% growth per year on Marty’s investment. This is financial leverage.
Suppose Marty borrowed $240,000 and only used $10,000 of his own money. What is his return on investment if growth is 2.1% per year? The equity position would now be $44,376 ($59,376 – $15,000 of additional borrowed funds) with a return on his investment of 36% per year. As more is borrowed, more leverage is exercised and therefore a greater return on an investment per year is earned.
Well, this sounds great! Why don’t more people use this tool?
Risk of Leverage
In order for leverage to work, the market’s growth rate must change. The problem with financial leverage is that it is financially devastating if market values decrease. Even a slight decrease in value can consume any equity that may exist. To illustrate, assume the market decreases in value a mere 1.5% per year for five years. What is the fair market value of the property now?
Year 0 $250,000 $250,000
Year 1 246,250 242,500
Year 2 242,556 235,225
Year 3 238,918 228,168
Year 4 235,334 221,323
Year 5 231,804 214,683
With a loan payoff of $218,000 Marty’s equity position is $13,804 or an annual loss of 11% over five years. This is at a 1.15% decrease in fair market value per year. If it were 3.0%, the fair market value of the building isn’t enough collateral to cover the remaining $218,000 loan balance remaining.
This is why so many investors lost tremendous wealth when the real estate market decreased upwards of 25% over two years back in 2008. Prior to the crash, leverage was extended with only one or two percent initial equity invested in the property. Today lenders are more cautious and require greater equity positions in real estate by investors. Gone are the days of loose money or borrowing to a high percentage (90 – 95%) of the fair market value of the asset.
If the property does well, the fair market value is much greater and it is tempting to access that value. One of the most expensive mistakes real estate investors make is refinancing the property every few years to ‘Cash Out’ as the saying goes.
One of the tenets of the tax code (Chapter 26 of the U.S. Federal Code) is the ‘Wherewithal to Pay’ principle. When a taxpayer has the cash from a taxable event, the taxpayer must pay their tax at that moment in time, often via estimated taxes.
When an investor in real estate has equity in property that has accumulated due to an increase in value over time he has what is called unrealized gains. This is similar to owning stock and holding stock for an extended period of time. If that taxpayer borrows money against that stock’s unrealized gain using the stock as collateral the Internal Revenue Service defines this as constructive receipt and therefore it is taxable income.
The same principle applies to real estate investment. Taking cash for your unrealized gain in the property and using the property as collateral is a taxable event. A real estate investor should not borrow more than the available tax basis in the property. I’ll illustrate using the case with Marty above.
Suppose Marty decides to use his equity of $59,000 in year five to borrow money via a second mortgage and borrows $40,000. For this I am assuming Marty has neither recorded any tax gains nor losses since purchase. He merely has his original $25,000 investment in the property. If Marty borrows $40,000 then $15,000 ($40,000 – $25,000 tax basis) is taxable as taking cash on the portion of which Marty has no tax basis. Basically any amount up to $25,000 is tax free because Marty is simply borrowing against equity that already has been taxed.
Do not believe these so called experts that tell you that by using the proceeds for additional property purchases defers the tax obligation. This is only true in narrowly defined situations. The only commonly acceptable exclusion is borrowing money on your personal residence.
I have had clients come into my office and have cashed out their commercial properties and used the cash for personal purposes. The tax bill can get very expensive. At a minimum 20%, sometimes upwards of 35% depending on the circumstances. Seek out advice from your CPA before taking a second mortgage or refinancing an investment property.
Summary – Financial Leverage with Real Estate
Financial leverage in real estate refers to using another person or entity’s money to gain higher profits as the real estate value increases. The growth in value is on both the investor’s actual investment and the amount borrowed. Be careful though, negative growth has a compounding effect. It is onerous on the an investor’s equity position in real estate and can quickly consume any actual equity.
Finally, seek advice from a CPA before refinancing or issuing a second mortgage on investment property. Almost all cashing out events are taxable under the IRS Code. Act on Knowledge.