Leverage is a tool that allows you to increase your return on equity with the help of foreign capital. In the case of investing in a mortgage; the lower the interest rates on the loan, the higher the leverage effect.
What is financial leverage?
Leverage is a tool that allows you to increase your return on equity with the help of foreign capital. In the case of investing in a mortgage; the lower the interest rates on the loan, the higher the leverage effect.
Buy to Let
Normally, you can achieve a return on your investment of about 4 to 5% per year for residential properties in Prague and the surrounding area. Better investments can achieve more than 6%. However, this often requires experience and a patient search for a suitable property.
Buy to let with financial leverage
With leverage, you can achieve a return on your investment of over 10%.
An example of leverage
You can use financial leverage in several ways when investing and then renting the real estate. I will give you at least one example of how to use financial leverage to increase a property’s value.
Suppose you buy a property for 2,000,000 Czk and assume that the value of your property will increase by an average of 2% per year. According to the Czech Statistical Office (www.czso.cz), this is a long-term realistically achievable result, even when taking into account short-term declines in the real estate market
If you finance the property exclusively from your own resources, then the appreciation is 2%. However, with inflation typically running at 2%, you will not actually increase your wealth. Your investment will only protect you from inflation, nothing more.
However, suppose you finance a portion of the purchase price of a property with a mortgage:
| Your own funds | 500.000,- Kč |
| Mortgage | 1.500.000,- Kč |
The share of foreign capital investment is therefore 75%. The cost of the interest on the mortgage and amortization should be fully covered by your rental income and therefore does not need to be taken into account in the following calculation. If the rental income does not cover this cost, you have not invested well.
A two percent increase in the price of the property means that in 1 year the market price of the property will be 2,040,000 Ckz, however you have only invested 500,000 Czk.
The yield or return on investment (ROI) = annual return on real estate value increases / investment
ROI = 40,000 / 500,000 = 8% annual return
If you have 2,000,000 Czk at your disposal, it may be more advantageous for you to buy many properties instead of just one. Using your two million as a deposit on multiple mortgages.
If you buy two properties with a total value of 4,000,000 Czk and use a mortgage to pay for the other 50% of the acquisition price, the return on investment resulting from a two percent increase in the value of the property will be 4% ROI = 80,000 / 2,000,000.
Similarly, you can invest in property with a total value of 8,000,000 Czk (if, of course, you have a good enough credit rating at the bank). With a 25% equity ratio, you will receive a return of 8% per year on your two million investment. ROI = 160,000 / 2,000,000.
The actual ratio of debt to equity should reflect your financial capabilities, it should therefore factor in some financial cushion for potential risks, such as a collapse in the rental market. For example, the COVID pandemic was disastrous for the holiday rental market in Prague.
Leverage is a good servant but a bad master
Over-lending can be very dangerous even for experienced investors. Fluctuations in the real estate market are not as dramatic as in the stock market, but they do exist. Just look at the decline in property prices from 2008 to 2013. The economic performance of every country fluctuates in cycles, which of course has an impact on the real estate market and this phenomenon must be taken into account.
Real estate investments are long-term investments. It will not pay in the short term. If quickly selling, you must take into account transaction costs, including a real estate acquisition (transfer) tax, which at time of writing is set at 4% of the sales price. In the short term this can easily erase your entire profit. It makes sense to invest in real estate if you want to have assets stored in them for at least 5 years, rather longer. After owning a property for this long, the real estate acquisition (transfer) tax no longer applies (at time of writing). Personally, I follow the principles of Warren Buffet, who said “The most popular time to hold an asset is forever”. From a long-term perspective, investing in real estate is very promising, provided, of course, that you know what you are doing.
Just as financial leverage can be used to increase the investment value of a property, you can apply the same principle when renting and thus multiply the income even more. With a lease, it is possible to achieve a return on equity of over 10% thanks to financial leverage, if you judge the market well and do your maths correctly.
Article prepared by: Bc. Petr Podlešák, manager at RE/MAX Alfa
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