How Using Leverage Can Be Helpful And Hurtful

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Recently the Toronto Star spread an article about a woman and her common law partner buying 5 properties in Brantford, Ontario. The goal was to achieve a passive income of $25,000 a month on rent so that they could retire. She had achieved all this, including buying her own home at the age of 33! This sounds like the dream that everyone wants. Own property, rent it out, get rich and retire! Are we all envious of this woman?

Unfortunately we’re not as fortunate to make it happen. She must come from a wealthy family like the Weston’s or the Thompson’s, but wait… that’s not true. She accomplished the feat of buying 6 homes without the help of any family members or relatives. How can that be? It has to be a lie, right? Actually, it can be done, but not without a lot of risk.

Location, Location, Location

First off she didn’t buy her houses in an expensive GTA neighbourhood. She bought them in Brantford, Ontario. Before people start saying how close Brantford is, let’s just take note that it is west of Hamilton! It’s a 1hr 15min, 100+ kilometer drive in good conditions. Imagine how long it takes in rush hour on the QEW! It’s also Brantford, Ontario. Not downtown Toronto. So don’t expect the restaurants, pubs, and night life to be available there. At least they have the Wayne Gretzky Center.

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Checking realtor.ca you can easily find many detached 3+ bedroom homes selling for roughly $225-250K. Yeah, that’s it! A measly quarter million. This place hasn’t had the rocket like increases that Toronto has had in home prices but partly because it’s Brantford, Ontario. Good ole Brantford, Ontario.

So homes are much more affordable in this Golden Horseshoe town near Lake Erie. That means it’s much easier to save up for a down payment.

Leverage, Leverage, Leverage

Time and time again I’ve already said that our financial system values property more than anything else. It’s the only asset that a bank is willing to leverage 20 to 1. This is probably the secret to actually accomplishing what this woman did. Use leverage to her advantage and buy many homes.

Since she started investing many moons ago, 5% downpayments and 30 year mortgages were all the rage. That would mean she would only need around $10K to start her plan. You might be reading this and think that $10K wouldn’t even get you through the front door of an open house in Toronto.

Since the cost of housing is a lot less out in the boonies, it’s quite possible to start off with a small down payment and only have to cover a small mortgage of $200K. In today’s low interest rate environment, that equates to only a $750 monthly mortgage payment. Less than leasing an Audi or maybe a parking spot in the big city! Since she rents out the homes for $1300-1500 a month, the property is actually generating a net profit per month. Probably between $400-600 after property taxes and insurance.

Great that gets one home, but what about the other 4? Considering only $10K is needed for a downpayment, that’s not too hard. The $400-600 a month in profit can be used. Add in some savings from her work and perhaps taking out the equity in the homes that are bought. Remember that once 20% of the house is owned, the remaining 80% can be withdrawn as a HELOC. That means that once there is $40K or so in equity, each dollar thereafter can be withdrawn from the home used for a downpayment. Leverage up some more baby!

This pattern of borrowing against her assets and flipping around to buy a new home means it’s possible to have a minimal investment and turn it around to buy over $1.2M dollars worth of property! How’s that for leverage. She started with around $10K and made an empire. Donald who?

Risk On!

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You must wonder why banks would allow someone to leverage so much? For one, profit. They make business by giving out loans. Two. They love houses as much as you do. Ever wonder why the bank representative asks you why you haven’t bought a home yet? Three. They have no risk. CMHC ensures all these high risk mortgages so that means the risk is on the taxpayers not the banks.

On top of all that, mortgage rules are strange in that 100% of the rental income can be included in the mortgage application. If the rental rates are greater than the cost of the monthly mortgage payments, then it makes it much easier to get a mortgage. In expensive markets like Toronto and Vancouver this may not be the case where rentals aren’t even cash flow positive.

This means those that bought homes before the 20% downpayment rule for investment properties was introduced in 2013 got lucky. They were able to leverage 20 to 1 on many properties which have now increased a lot in value.

This plan sounds amazing, but what it doesn’t factor in are the risks associated with being a landlord. Bad tenants or vacant units can really put a damper on maintenance costs. What happens when a tenant damages the place? Or they fail to pay rent? If the property is vacant for an extended period of time the owner takes the hit directly.

A larger oversight in this investment portfolio is the lack of diversity. Essentially this individual has decided to put all their money on real estate. It’s an asset class that is prone to downturns just like a stock market. And perhaps even worse, real estate is completely emotional and completely irrational. Who knows what will happen when?

With recent news of rate hikes, where’s the protection against rising interest rates? What happens if people decide to leave Brantford en mass because they are tired of living so far from Toronto? What happens if she needs money immediately? Selling a house can be both costly and very time consuming. Just ask those in the GTA right now how hard it is to sell a house.

The worst is if home prices start to fall. Borrowing money from homes using a HELOC has dire consequences because owners are only allowed to borrow up to 80% of their equity. This means if home prices fall and the loan breaches that 80% threshold, owners will be forced to sell their homes to make up the difference. Have enough homes where equity is leveraged to the hilt and you can see why once the dominoes start falling, they start falling fast.

Is Real Estate The Only Way To Retire?

The thought that real estate is the only way to achieve financial independence is completely wrong. It’s entirely possible to be wealthy without owning real estate at all, but it takes patience, perseverance and will power.

The best approach is actually to be well balanced and diversified. Have real estate, but make the purchase reasonable. Pair that with a well balanced investment portfolio of bonds and equities. Make sure you own everything so you can withstand any shock to the market.

Just remember that regardless of what you do, you can only achieve financial independence if you have your money work for you. In today’s economy where jobs are scarce and salaries are stagnant, the only way to get ahead is to have your money do something for you. Besides we humans only have so many hours in the day that we can be productive, whereas money can be working for you 24/7. Don’t you want to get rich sleeping?

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