When investing in real estate, many people often compare the returns of a cash purchase versus a financed purchase. However, this comparison can be misleading, as it doesn't take into account the actual money that leaves your pocket when financing the property. In this blog post, we will discuss the importance of measuring returns based on your actual cash outlay when using financing and provide a practical example to illustrate the power of responsible gearing in property investment.
Why Financing Matters:
When you finance a property, your initial investment is significantly lower compared to purchasing the property in cash. This means that you can generate higher returns on the money that you actually invested, as long as you manage the risks associated with financing responsibly.
Consider this example from our discussion:
An investor buys a property for R2,000,000 with 100% financing and R60,000 in buying costs. The property is financed over 240 months at a 10% interest rate, amortized monthly. The rental income is R15,000 per month with an 8% annual escalation. There are also monthly expenses such as levies, rates and taxes, and rental management fees. The property experiences a 7% annual growth in value.
With these assumptions, the investor starts generating positive cash flow in the 7th year, and the property value, less outstanding debt, is approximately R1,367,680. When calculating the internal rate of return (IRR) based on the cash outlay (R60,000 initial investment and the negative cash flow during the first 6 years), we find that the IRR is approximately 65.28%.
On the other hand, if the investor had purchased the property in cash, their return on investment (ROI) would be significantly lower, at approximately 20.99%.
The Power of Responsible Gearing:
It is important to note that in the journal of property investment and finance, leveraging financing in property investment comes with risks. Irresponsible gearing, such as overextending yourself with too much debt or not having a contingency plan for vacancies or unexpected expenses, can lead to financial troubles. However, responsible gearing can be a powerful tool for growing your property portfolio and increasing your returns.
In our example, the investor was able to achieve an impressive IRR of 65.28% by using financing responsibly. This was achieved by carefully managing expenses and taking into account the potential risks associated with financing. The key takeaway here is that financing, when used responsibly, can be a powerful strategy for maximizing your returns in property investment.
When evaluating property investments, it is essential to measure returns based on the money that leaves your pocket, especially when using financing. By doing so, you can better understand the true potential of your investment and make more informed decisions.
Responsible gearing can be an effective strategy for property investors who are well-prepared and understand the risks involved. By leveraging financing, you can grow your property portfolio, increase your returns, and ultimately achieve your investment goals.
Remember, the key to success in property investment is proper planning, responsible risk management, and leveraging the power of financing to your advantage. Happy investing!
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