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A couple who are clients of mine own, free and clear, a rental house that is part of their income-producing assets. The last time we evaluated their portfolio, I suggested they consider a couple of changes regarding this property. One option would be to take out a mortgage on this house and invest that money elsewhere, probably in more real estate. Another would be to sell the property, and via a 1031 tax-deferred exchange, replace it with a more valuable property with a mortgage.
They asked me to explain why it would be better to mortgage a property than to own it free and clear. Here is the explanation.
First of all, an investment property that is paid for produces a return. The gross income (rent paid by tenants), less the operating expenses (taxes, insurance, maintenance, etc.) equals your net operating income. Typically, the net operating income will run between 7% and 10% of the value of the property. This is the capitalization rate or cap rate for that property. If your income property is worth $1,000,000, you can expect it to generate $70,000 to $100,000 annually. In addition to this, you earn any appreciation that results from an increase in the value of the property.
Let’s take an example of a property worth $1,000,000 that has an 8% cap rate and a 2% inflation rate, for a total return of 10%. Your yield from that property (the 8% net operating income plus 2% appreciation) will be $100,000 per year.
If you borrow against the property, your yield goes up. Here is how that works. Let’s say you borrow $500,000 on your $1,000,000 property at an interest rate of 7%. Your mortgage interest in a year will be $35,000. When you deduct that from your $80,000 net operating income, you have $45,000 cash flow.
It may seem as if you’re earning less money from this property. With the mortgage, though, your equity in the property is $500,000 rather than $1,000,000. Your return on that equity is 9% ($45,000 divided by $500,000). Without the mortgage, your return is 8% ($80,000 divided by $1,000,000). The inflation rate of 2% means that the property increases in value by $20,000. That increases your $500,000 equity to $520,000, a return of 4%. Your total yield using the mortgage is 13%, rather than the 10% yield you get if you own the property free and clear.
Suppose you borrow $700,000 instead of $500,000. At 7%, your interest will be $49,000. Subtracting that from your $80,000 net operating income leaves $31,000 cash flow. Since you now have $300,000 in equity, your return ($31,000 divided by $300,000) is 10.3%. Adding the $20,000 appreciation increases your equity to $320,000, a return of 6.7 percent. Your total yield then is 17%.
The more you borrow, or leverage, the higher your return will be. Of course, your risk will be higher as well because a greater proportion of your property will be mortgaged.
These examples, of course, are simplified. They don’t take into account any reduction of the debt or other factors that would affect a decision to mortgage a piece of investment property. Some of those include:
· Whether the income from this property is part of your investment portfolio or cash flow that you need for living expenses.
· The tax implications, such as the mortgage interest being a deductible expense.
· What kind of return you could gain from investing the money borrowed against this property.
When you consider those factors, mortgaging your investment real estate might be an even more desirable choice. In many cases, it is a wise way to get a higher return on a real estate investment.
