Why you should always apply for a mortgage when you decide to buy a property in Trinidad and Tobago!
Real estate investment is a relatively expensive asset class which has long been known to produce steady and predictable cash flows. These predictable cash flows are through rental income which allows investors to borrow large amounts of debt that can be paid back over a long period of time. The greater the amount of debt, the smaller the cushion between the net operating income and debt service payments. Though, once the net operating income can service the debt payments (principal + interest) the mortgage can be acquired. This allows most property investors to borrow as much debt as the property income can service.
Ever wondered if these mortgage payments can increase your overall investment returns?
Let’s compare the cash flows in a simple example below to see exactly how a mortgage can impact property returns.
Return On Equity Example:
Assume an investor with $5,000,000 TTD and wanted to allocate it into property. He would have two options for his investment. Option 1, buy a $5,000,000 TTD apartment with his own equity, or Option 2, use a mortgage to invest in a much larger property valued at $15,000,000 TTD.
Note that in both investment options the amount of equity that has to be locked into each of the properties are equal while the amount of rental income being produced by Property 2 is roughly 3 times the amount of Property 1. If a mortgage of $10,000,000 TTD was taken out on Property 2, it would allow the buyer to afford a property 3 times the value of his original investment option for the same $5,000,000 TTD in equity output.
Using Leverage to Increase Investment Returns
As seen in the calculation above, the after debt return on Property 1 vs. Property 2 is a $5,000 TTD difference per month. This results in a 1.2% higher yearly return on equity for Property 2 even though the investor put out an equal amount of equity that was needed for Property 1. If a loan was issued for $10,000,000 TTD to buy Property 2, the monthly mortgage payment would be roughly $45,000 TTD. With a rental income of $75,000 TTD, Property 2 can service its mortgage payments while still providing more income to the investor than Property 1.
Another benefit of using debt is that not only year on year cash flows are higher, but at the end of the investment’s lifetime, the investor will own a property worth 3 times the value if he purchased Property 2 using leverage vs. Property 1 using no leverage. On top of the fact that if there is any capital appreciation on the Property over the life of the investment, Property 2 will experience magnified returns on capital appreciation vs. Property 1.
The last true benefit of debt, is offering investors a tax break. With commercial property taxes as high as 30% in Trinidad and Tobago any investor would go above an beyond to find a way to mitigate this expense. The interest portion of the debt service repayments can be deducted from taxable income. This has a massive effect on total property returns and which is one of the main reasons most investors use high levels of debt to alleviate tax payments throughout the life of the investment!
More Debt, More Risk!
As seen in the example, debt can have a powerful impact on increasing returns, however, debt also adds risk to an investment:
• Debt magnifies returns in both directions. Not only does debt increase percentage returns during value appreciation, but sadly this same effect holds true if property values decrease.
• Debt payments take priority over equity returns to the investor and must be repaid!
• Loans typically have a fixed date by which they must be repaid.
• In an economical recession, reduced rental income or high vacancy rates can mean zero income and debt repayments will still be due! Therefore debt can definitely increase the risk of an investment!
Mortgages can definitely be a great tool for enhancing property returns as well as allowing property buyers to invest in much larger properties. But with more debt, comes more risk! Remember when understanding the amount of debt you should take out on a property it is very important to understand future cashflows of that property to a high level of accuracy. Don’t forget to leave some safety margins in your cash flow analysis to provide a cushion in the event that the economy takes a bad turn!
The PropSnoop Team