Property Investors can Benefit from Low Mortgage Rates
Low interest rates can help boost real estate investment returns and result in positive leverage, under certain conditions. The term positive leverage refers to the case in which the use of borrowed funds increases the return on the capital that the investor will put from his own pocket (this is referred to as equity), compared to the return that it would be achieved without any borrowing. If certain conditions are not met, the borrowed funds to finance a property acquisition can have a negative effect on property investment returns as well. A simple methodology to evaluate whether borrowing will result in positive leverage is to compare the rate of return on total capital with the mortgage constant of the particular loan that is considered for financing the property acquisition. The mortgage constant represents the amount needed to service the loan over a given period as a percent of the total loan amount. For example, the monthly mortgage constant represents the required monthly loan payments as a percent of the total loan amount. One of the major factors that determine the mortgage constant for a particular loan is the mortgage rate. Hence, a lower mortgage rate results in lower mortgage constant, if we keep the term of the loan and the loan amount constant. The mortgage constant applies to fixed-rate loans, and is always higher than the mortgage rate because it includes both interest and principal payments. The technique of comparing the mortgage constant with the return on total capital in order to determine whether positive leverage can be achieved is a simplistic methodology and has deficiencies. First of all, the NOI of the property under consideration may change significantly over the holding period of the investment, while potential capital gains or losses are ignored. In addition, the impact of income taxes on investor return is not taken into account because NOI is a before-tax cash-flow measure. In order to accurately evaluate whether borrowing will improve investment returns, a complete discounted cash-flow analysis of the property investment under consideration is required.
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