Are leveraged investments a good or a bad thing ?
I think a bad investment is anything you don’t fully understand and anything you don’t have control of. When I say control of, I don’t mean direct control as one never has control of the companies you buy stock in, but you control the buying process, the analysis process, the listening to advisors or reading articles process and the selling process. If you make an investment that misses some of these fundamentals then you’re setting yourself up for failure.
Leveraged investments are the same thing. You need to understand what you’re getting yourself into. What makes the investment work? What are the pitfalls? How can they be avoided? Are they manageable? What is the outcome? What is the IRR? And what are the cash flow implications?
Rental properties are something I got into when I first moved to Europe. I started out being a consumer and renting a furnished property. I immediately noticed (before signing the lease) that the rental amount was higher than the non-furnished properties, but given my reluctance to buy all the required assets to furnish an apartment, which was based on my estimated time in the country at that point, I decided it was more worth my while to rent furnished, despite the higher monthly charge.
My conclusion of my one year rental?
There was a gap in the market.
How did I conclude that?
It was easy: The furniture in my apartment was really low quality, yet the incremental rent above a non-furnished rental was meaningful – at least a few points by my estimation at the time. But I needed to ascertain a number of key points before I would be ready to finance my own investment:
- What were the tax implications if any? Could I deduct certain expenses against the revenue? How was the profit (or loss) handled?
- What was the market size? What was the competition like? What ware occupancy rates like?
- What were reasonable rental yields on the market?
- What would the cash flows look like? Would I need to cover the cash needs in the early years and for how long?
- What would happen if the apartment was empty for an extended period of time? Basically how long could I last before it put my living cash flow at risk?
- What was my ideal investment amount given the above?
The above points are important to check off and to fully understand before starting any financial analysis of the returns. Being able to cover the expenses (loan amortization, interest, etc) if the apartment was empty and for a reasonable period of time is important as you don’t want an investment to compromise your day to day living expenses or your other investments.
Then there was how much risk was I willing to take on.
Everyone knows that higher risks can mean higher returns, but they can also mean higher failures. This is hard to ascertain for anyone. Sure there are always those questionnaires that you can fill out that can tell you if you are a risk taker or not, but those are just indications. This part isn’t a science.
Could you live with the fact that a tenant might leave and then 3 months later you run out of cash as you can’t find a replacement tenant? Could you sell the place in the following 3 months and recoup your money? Could you bridge those latter 3 months with some form of short term debt? What about the property market? Is it going up or down? If you’re forced to sell would you take a loss? Could you cover it?
But then again, would the apartment sit empty for 3 months?
That just brings us back to question 2 above and to my point “you need to understand what you’re buying into”.
Let’s look at my example when I bought my first property 11 years ago, in 2005, a two bedroom that I remodeled into a 1 bedroom. I won’t take you through all my answers to the above questions as each investment is unique, but I want to show you the returns of this one investment.
It took me three years to finally make the decision to do this. I tend to overanalyze sometimes – which isn’t a bad thing when there is money to be made (or lost).
Purchase price: 240.000 euros
Down payment: 20.000 euros
Loan: 220.000 euros
Monthly rental: 1.000 euros
Monthly loan payment: 1.500 euros
Remodeling expenses and other purchase costs: 25.000 euros
Furniture and fittings: 5.000 euros
I won’t include the electricity and other expenses like insurance in the analysis, but it is good to capture that as well. The apartment was well furnished with quality furnishings and all redone, so the interest from prospective tenants was solid to start off with. I added in free internet, which was a differentiating factor back then.
The rental yield (rent divided by purchase price) was 5% to start off with and I had to finance 500 euros a month. I calculated that I could afford 2 months of the apartment being empty before I had a problem. To offset that I bought in a central location that was sought after and did a lot of the work myself, so the remodeling cost was fairly limited. My ‘all costs included’ rental yield was about 4.4%.
After 11 years the apartment has maybe been empty a full week, excluding a one month down time when I completely redid it again.
This is where the property stands now:
Current Value: 450.000 euros
Monthly rental: 1.300 euros
Monthly loan payments: Zero
So I have an asset that is slowly approaching half a million euros in value for which I conservatively have invested about 180.000 euros all in (including paying off the loan earlier this year). It brings in 15.600 euros a year and has an almost 100% occupancy rate. The rental yield on current value has fallen to about 3.5%, so theoretically I could sell and get a better return elsewhere, but given the property market, the tax implications of selling as well as my overall portfolio distribution I have decided to hold this asset a little longer.
Obviously buying into the current market will have lower pure rental yields, but I believe the rental could be significantly improved by targeting other segments of the market. Given some of the segments that are coming of age, like the serviced apartment segment, actual rental yields might actually be about 7% on current values so that’s the next step I am busy studying to see how I can boost this investment even further and make it work harder for me.
More to come on that later.