As a commercial real estate investor, you can increase your returns and pocket tax-free cash by utilizing leverage and refinancing (also known as using “Other People’s Money”). This benefit is just one of the reasons why investing in commercial real estate frequently comes out on top when measured with other forms of investing.
Leverage is the use of borrowed funds to complete an investment transaction. The higher the proportion of borrowed funds used to make the investment, the higher the leverage and thus, the lower the amount of equity required.
Here are some examples of how leverage works for you:
Magnify Your Gains in Price with Leverage
Assume you acquire a $100,000 property. You borrow $80,000 and put $20,000 down. During the following 5 years, the CPI advances by 50 percent, however your property lagged behind the CPI by only increasing 25 percent. Your real wealth went down, right? No, it increased. The $100,000 property is now worth $125,000 so your equity wealth (your original $20,000 down) has grown to $45,000. You have more than doubled your money, while inflation has only increased your $20,000 to $30,000. Real estate investing builds wealth because it grows acorns (small down payments) into free and clear properties worth many multiples of the original amount of invested cash.
Magnify Returns from Cash Flows with Leverage
Traditionally, investors not only magnify their equity gains from leverage, they also magnify their rates of return from cash flows. You pay $1,000,000 cash for an apartment building that yields a net income (after all operating expenses) of 7.5 percent with no financing. Not bad. But if you finance $800,000 of that $1,000,000 purchase price at, say, 30 years, 5.75 percent interest, you invest just $200,000 in cash. Your net income equals $75,000 (7.5% X $1,000,000) and your annual mortgage payments (debt service) will total around $56,000. You pocket $19,000 ($75,000 less $56,000). You’ve boosted your cash flow return (called cash on cash return) from 7.5 percent to 9.5 percent ($19,000 divided by $200,000).
Refinance to Pocket Cash without Paying Taxes
Refinancing occurs when a commercial real estate investor replaces their existing financing with new financing.
Say after 10 years your $1,000,000 property is now worth $1,500,000. You’ve paid down your loan balance to $650,000. Your equity has grown from $200,000 to $850,000 ($1,500,000 less $650,000). You obtain a new 80 percent loan-to-value ration (LTV) mortgage of $1,200,000. You pocket $550,000 tax free. However, I suggest that you don’t spend that cash. I suggest that you reinvest it. Buy another income property. Yes, you now owe higher monthly mortgage payments on your first property and your cash flows from that property will decrease. But with the additional cash flows from your second property, your total cash flows will go up.
As a commercial real estate investor, that’s called having your cake and eating it, too!