Buying property is not like investing in stock as you can’t just put a little here and there but instead, you will need capital to purchase a property. Flipping properties is not that easy as there are risks involved, and you need to work on a budget plan with an emergency fund and be prepared to bite the bullet.
However, there is a way to get into the property market to increase your net worth if you know how to use leverage to your advantage. This is to say, and you can use debt to help you realize a return.
What is Leverage?
Leverage is the use of borrowed capital, in other words, debt – to increase the potential return of an investment. While the potential is for a good return on your investment by selling the property higher than what you paid for, it is NOT totally at no risk. It can also lead to losses if the investment moves in the opposite direction. Losses happen when property prices decline.
Leverage to Increase Your Net Worth
If an investor purchase a private property of $500,000, with Loan-To-Value (LTV) at 75%, the investor will need to will be paid around 5%, i.e., $25,000 in hard cash (exclude other property costs) and 20%, i.e., $100,000 from your CPF, and can borrow $375,000 from a bank.
By putting down only 5% cash and 20% from the CPF Ordinary Account (CPF-OA) fund and borrowing the rest, the investor essentially uses a small percentage of their own funds to make the purchase. The majority, therefore, is provided by the bank.
Let’s assume the property appreciates at a rate of 5% per year. This means the property value grows to $525,000, $25,000 in just 12 months. This means the Return on Investment (ROI) is 20% ($25K/$125K). Comparing this gain to the gain from the investor paid in cash with no loan, i.e., $500,000, the ROI is only 5% ($25K/$500K). This highlights the value of the leveraging strategy. And if the investor rented the place out, this is like using other people’s money to finance your property while waiting to sell at a capital gain.
The Dangers of Leverage
All sounds good, but there is a downside. For the same example, if the property price in your area declines, the leverage works in reverse. After one year, your $500,000 property could worth $475,000, depreciates by 5%.
Just as leverage can work in your favour, it can also work against you.
In property markets where prices fall, homeowners can end up owing more money than the house is actually worth. For investors, declining prices can reduce or even eliminate profits. If rents fall, too, the result can be a property that cannot be rented at a price that will cover the cost of the mortgage and other expenses.
Leveraging Many Properties
The goal of leverage your money is to take control of 100% of the assets while only putting down 25% of the price. Consider the $500,000 property in our example. Since it was purchased with $125,000 cash as downpayment, if the property’s value declined by 30%, the property will worth $350,000. However, the buyer will still need to pay interest and principal in the full value of the $375,000 loan. The amount the investor gets in rent decline as well, the decline in the rental income/cash flow from the property to pay the mortgage could also affect the entire property investment.
When it comes to the “how to sell one HDB flat and buy two condos” approach, it mainly works through the power of leverage. It is “sell one and borrow enough money to buy two.” This is to sell your HDB flat and get the sale proceeds in cash to see whether it is possible for you and your spouse to each buys a private property, typically one bigger property to live in and another small one for investment in the form of rental. This avoids Additional Buyers Stamp Duty (ABSD), as each of you are buying a single home, not a second home. At the same time, the rental income can more or less cover the costs, leaving you with an appreciated asset to sell in the future for retirement.
For this approach to work, it is important to assess your financial health and how you want to repay your housing loans using cash versus CPF to work on your advantages to grow your retirement funds.
Avoiding Leveraging Risks
Any form of investment comes with a risk, so it applies the same to property investment. Although you can use leverage to your advantage, there are a few key considerations when you are taking more leveraging multiple properties:-
- It would help if you had savings – enough to keep the loans paid for at least the next six months in case of a decline in income due to retrenchment or any unforeseen circumstances.
- The monthly costs of the property do not take up more than 40% of your monthly income. If you are the sole breadwinner, then the monthly costs of multiple properties should not take up more than 40% of your monthly income.
- You have other financial protection, such as comprehensive health insurance.
- Your retirement portfolio does not consist of properties. You should have a mixture of stocks, fixed deposits, CPF, etc.
It is wrong to assume all properties will appreciate or property values will rise. It is not necessarily the case that market trend will continue the same path. Do factor in the worst-case scenario to ensure you prepare yourself when things go south.
Budget yourself accordingly and know what you’re getting into. If you put down a lower downpayment, the amount of your loan will be higher. That means you will have to make a larger mortgage payment. Ultimately, you are still responsible for the mortgage payment, so you have to make sure you can keep yourself afloat in any situation. If you depend on rental as a source of income for mortgage repayment, you may have to account for lower vacancy rates, a tougher economy, bad tenants—all of which will fall on you.
Leverage uses borrowed capital or debt to increase the potential return of an investment. Many people take on housing loans when they purchase properties. They often do not think of it as leverage but taking out a mortgage to buy a home. They pay back the loan over a period of years or decades while enjoying the use of the property. The moral of the story is that leverage is a common tool that works well – when used prudently.