Should you finance your Real Estate Investment

I want to own income property, but how do I do that? Should I continue to save until I have enough to buy one, should I buy off plan, should I get a mortgage?

Each one of these options has many things to consider. If you try to save, it might take you a long time to keep enough to purchase a property, and with inflation, the property prices might rise faster than your savings. If you purchase off plan, you don’t know when it will be handed over, how much it will be rented for, and you will be obligated to pay for a while before you can start earning any money. A standard approach money take is financing their real estate investment. Yes, there are many valid reasons why it makes sense to finance real estate, but there are many things to consider before making such a commitment. If done right you can make good money, but if not planned properly you can also lose a lot of money.

So, lets first talk about why it makes sense to finance the property. Firstly, it allows you to get started with a small amount of savings. Depending on the local rules and regulation you might need anywhere between 5-30% down payment to finance the remaining from the bank. In countries where the down payment requirement is lower the easier it will be for you to get started. In a place like UAE, you will still require a lot of money for a down payment.

Assume you want to start with 500,000 AED studio apartment, you will need at least 150,000 AED to get started.  Financing allows you to buy an asset with the little bit of equity meaning your own money and the rest is provided by the bank for which you must pay interest. Continuing with the example of 500,00 AED studio, you will need only 150,000 AED and the remaining 350,000 AED can be borrowed from the bank. Let’s assume you borrow 350,000 AED from the bank for 25 years at a mortgage rate of @ 4%. This will translate into annual mortgage payment of approx. 22,200 AED.

Now let’s assume you could rent that property at 40,000 AED and your service charges are 6,500, your net income from this investment will be approx. 11,300 AED. That is 40,000 less annual mortgage payment of 22,200 and service charges of 6,500 for a total net income of 11,300. That is 7.5% return on your initial investment of 150,000. Not too bad!

Now let us compare this to if you had bought the property outright for AED 500,00. Meaning you didn’t borrow any money from the bank and used AED 500,000 of your own money to buy the property outright. You would still rent the property out for 40,000. Your obligation in this scenario will be only the services charges of AED 6,500 meaning your net income will be AED 33,500 as you are not paying any payments to the bank. You are making more money, but you also invested a lot more, AED 500,000 compared to AED 150,000. In this scenario, your annual return is 6.7%.

Financing appears a better option? You needed less money to invest, and you earned a better return on your capital. Do you need more proof? Let’s continue before concluding.

The other benefit of financing is that you can build equity in the asset as you are paying down debt. And the best part is that someone else is paying the mortgage for you as you have rented out the property. To explain this let’s continue with our example.

Assume in 5 years you can sell the property for 550,000. If you financed it, you would make a gross profit of 250,000. You will sell for 550,000 payback the bank the remaining outstanding balance which in 5 years will be approx. 300,00 AED and keep the remaining AED 250,000 for yourself.

So, your AED 150,000 investment turned to AED 250,000 a return of 100,000 in 5 years. Remember you also made 11,300 every year in rental income for five years for a total of 56,500 bringing your total return to 156,500 a 105% return in 5 years. You doubled your money. Wow! This is starting to get the one-sided argument.  How come not everyone is doing this? Be patient, and we will get to the answer together.

Now let us compare this to if you had bought the property out right without financing. Assume you sell it for 550,000 AED your profit will only be 50,000 AED. You bought it from 500,000 and sold it for 550,000. But remember your annual rental income was higher in this scenario, you were earning 33,500 a year and over 5 years that would be a total of 167,500. So, your total return will be 217,500, 50,000 gain and 167,500 in rental income. It’s more money than the financing option but remembers you also invested more money here. You had invested 500,000, so a return of 217,500 is a 43.5% return on our investment over 5 years — approximately half of what you earned if you had financed it.

But it’s important to notice the difference between the two options. In financing your total return of 156,500 was predominantly made up from the capital gain, i.e. selling the property at a higher price. Of the total return of 156,500 almost 64%, i.e. 100,000 was made up of capital gain, and only 36% (56,500) was from rental income.

Whereas if you bought it outright, the majority of your return came from rental income. 77% of the total return 217,500 came from rental income and only 23% from capital gains.

Why is this important? Because when you buy an investment property, the rental income is more certain than price appreciation. You can’t predict where the prices will be in the future. By hoping the prices will be much higher in the future for you to make money you are potentially taking on more risk than you can afford.

Both options had its benefits and given your financial situation one might make more sense than other. Owning the home outright provides you with a lot more flexibility and options compared to financing the property.

For example, imagine your property goes vacant for a full year. If you financed it, you would still need to pay the mortgage payment out of your pocket and the service charges amounting to a total of 28,700. What happens if you can’t afford that payment? You risk your 150,000 AED that you have put as a down payment. Alternatively, if you had bought it outright you will only need to pay the services charges at 6,500. Also, by not having any other obligation you can reduce the rent amount to rent it out and take a small hit on your income. You can also reduce the rent if you financed it but not as much as if you had bought it outright as you need to factor in the mortgage payment and the additional risk you have taken on.

Let us take the example further. Now imagine the worst has happened. The property is vacant, and the prices are going down. In a situation like this, you can be very vulnerable. If you are unable to meet your obligation you might need to sell the property., If you are lucky you will be able to sell the property for more than what you owe the bank and walk away without losing much money, but there is a risk that you might need to sell below what you owe the bank and have to pay more to get rid of the property.

Whereas if you had bought the property outright, you are not forced to sell in market downturns as long as you can rent at some amount and cover your costs you can sustain it much easier. Remember if you own the property outright you carrying cost meaning the amount required to sustain that investment is only the service charges of 6,500 which is more affordable than the service charges plus mortgage payment. So, you can be patient and wait for the market to improve to sell the property. If you finance, it and can’t meet your monthly mortgage payments, you might be forced to a bigger loss.

Imagine the prices have come down to 400,000 in 5 years. You have lost the value of 100,000 AED. 500,000 less current price of 400,000. In 5 years you still owe the bank 300,000. If you sell for 400,000, you will only get back 100,000 on your original 150,000. You would lose 1/3^rd of your money, 50,000. However, you would have still earned rental income over 5 years of 56,500. So, your total return in 5 years would be only 6,500. That is a lousy return of 4% over 5 years on your original investment of 150,000.

Compare this to you buying the property outright. You sell the property for 400,000. You lose 100,000 on your investment. i.e. only a 20% (100,000/500,00) loss on your investment compared to 33% if you financed it. But remember you were making more rental income in this scenario. In 5 years, you made 167,500. So, your net return would be 67,500 which is approx. 13.5% return over 5 years. Not great but better than the financing option.

Also, remember by buying the property outright you will have the limited obligation, so you are less likely to sell in the down market whereas if you financed it you are more likely to sell in the down market. This is the key. It provides you with more options and flexibility.

Quite a few broad assumptions in the example above but trying to make a point that when you own it outright, you have a lot more options than if you are to leverage an investment. Leverage can enhance your returns in good times and can make you lose your shirt in bad times.

The wealthy use leverage really well because they can afford it even during the bad time. They have enough wealth to protect themselves, but even then, many wealthy people go bankrupt when they are over-leveraged. You as an individual has to be careful not to expose yourself too much.

Once you leverage you expose yourself to additional risk such as interest rate risk. If the rates go up so will your obligation. When thinking of leverage, you need to pay attention to the margin you are gaining. What do I mean by margin? Say you are borrowing money at 4% and you can earn 8% on that money that means you have a margin of 4%. If interest rates start to rise and the returns start to come down that your margin will get squeezed and it might not be worthwhile given the level of risk.

In an environment like now where interest rates are rising, and the real-estate return is coming down one must be extremely careful to finance real estate.

But not everyone has the money to buy the property outright, in fact, many don’t have money to put a down payment. This is the reason Smart Crowd’s platform is ideal to invest in real estate. It allows people to get access to one of the most preferred asset classes in the world. You can start investing in real estate with whatever you can afford so you can put your money to work and earn a steady rental income. Learn more how you can invest in real estate while limiting your risk and with low minimum investment at smartcrowd.ae