Maximize Returns and Minimize Risks
Real estate investment is recognized for its ability to create lasting wealth. One of the most powerful mechanisms for amplifying these gains is financial leverage. But what exactly does it mean, and how can we use it wisely?
Explanation of Financial Leverage
Financial leverage is the art of using debt to strengthen the power of your investment. Instead of being limited to your initial capital, you can borrow to increase the total amount invested. For example, with a contribution of 15,000 CAD, you could borrow 85,000 CAD, bringing your total investment to 100,000 CAD.
Leverage in the Real Estate Sector
Real estate offers a unique opportunity for leverage. It allows you to acquire assets worth more than your initial contribution. The rents collected can then cover the repayments of the loan, while generating profits.
The Risks of Leverage
It is essential to recognize that leverage, although powerful, carries risks:
- Défaut de paiement : Si les loyers ne couvrent pas les remboursements, vous devrez compenser la différence.
- Market variation: A decrease in property value can result in debt exceeding the value of the property.
- Rental vacancy: A period without a tenant can compromise your ability to repay the loan.
Example scenario
To better understand the concept of financial leverage, let's illustrate it with a concrete scenario.
Purchase without Leverage: Imagine that you want to buy an apartment for $1M entirely in cash. If, after one year, the value of this apartment increases by 2%, this represents an increase in value of $20K. If you decide to sell this building, your profit would be $20K on an initial investment of $1M, or a return of 2%.
Purchase with Leverage: Now consider using leverage to purchase the same apartment. Instead of paying the full amount, you decide to put down 10%, or $100K, and borrow the remaining $900K.
If the building takes the same value of 2% in one year, its value will also increase by $20K. However, your return would not be calculated on the total investment of $1M, but rather on your initial contribution of $100K. So, your return on investment would be $20K on $100K, or 20%. This is ten times the return you would have obtained without using financial leverage.
Risks of Leverage: However, leverage also amplifies losses. If, instead of increasing in value, the apartment lost 2% of its value, you would suffer a loss of $20K. In the scenario with leverage, this loss would represent 20% of your initial contribution, while in the scenario without leverage, it would only represent 2% of your total investment.
Final Thoughts
This example clearly demonstrates how financial leverage can increase returns tenfold. However, it is essential to remember that leverage also increases risk. An investor must therefore carefully evaluate his or her risk tolerance before deciding to use leverage. If you would like to learn more about real estate, consult our other articles in the education section.
