How a commercial real estate investor can generate higher returns

As a commercial real estate investor, you can increase your returns and earn tax-free cash by using leverage and refinancing (aka “Other People’s Money”). This advantage is just one of the reasons why investing in commercial real estate often comes out on top compared to other forms of investment.

Leverage is the use of borrowed funds to complete an investment transaction. The higher the proportion of borrowed funds used for the investment, the higher the leverage and therefore the amount of equity required.

Here are some examples of how leverage will work for you:

Magnify your price gains with leverage

Suppose you purchase a property worth $100,000. You borrow $80,000 and put back $20,000. During the next 5 years, the CPI increases by 50 percent, but your property underperformed the CPI, increasing by only 25 percent. Your true fortune has gone down, right? No, it has increased. The $100,000 property is now worth $125,000, so your equity (your original $20,000 loss) has grown to $45,000. You more than doubled your money while inflation increased your $20,000 to $30,000. Real estate investing builds wealth because it grows acorns (small down payments) into free and clear properties worth many times the money initially invested.

Magnify cash flow returns with leverage

Traditionally, investors not only magnify their stock gains through leverage, but also their cash flow returns. You pay $1,000,000 in cash for an apartment building that, without financing, has a net income (after all operating expenses) of 7.5 percent. Not bad. But if you finance $800,000 of the $1,000,000 purchase price at, say, 30 years and 5.75 percent interest, you’re only investing $200,000 in cash. Your net income is $75,000 (7.5% x $1,000,000) and your annual mortgage (debt service) payments are approximately $56,000. You collect $19,000 ($75,000 minus $56,000). You’ve increased your cash flow yield (called cash-on-cash yield) from 7.5 percent to 9.5 percent (dividing $19,000 by $200,000).

Refinance to pocket money without paying taxes

Refinancing occurs when a commercial real estate investor replaces their existing financing with new financing.

Suppose after 10 years your $1,000,000 property is now worth $1,500,000. You repaid your loan balance to $650,000. Your equity has gone from $200,000 to $850,000 ($1,500,000 less $650,000). You get a new mortgage with an 80 percent loan-to-value ratio (LTV) of $1,200,000. You pocket $550,000 tax free. However, I suggest that you do not spend this money. I suggest you reinvest it. Buy another investment property. Yes, you now owe higher monthly mortgage payments on your first property and your cash flows from that property will decrease. But with the additional cash flows from your second property, your overall cash flows will increase.

As a commercial real estate investor, this means: eat cake and eat it too!