Maximizing Returns Part 2
LEVERAGE Leverage involves the use of borrow3ed funds to make an investment in real property in the hopes of realizing a profit, in addition to monies necessary to pay for the borrowed funds. Most commercial real estate transactions involved borrowed funds for leverage, thereby reducing the owner’s initial investment and permitting him/her to participate in various projects within defined financial capabilities. Leverage has the potential to increase the owner’s return on any given investment, but risk is a consideration. Three types of leverage can occur. • Positive leverage – A situation in which the yield to an investor exceeds the overall rate of return that would have been realized on a property had no financing been put in place. • Neutral leverage – Occurs when no increase or decrease in yield occurs as a consequence of leverage. • Negative leverage – exists when the use of borrowed funds results in a lower equity yield than the overall rate of return that could have been realized has no financing been put into place. Leverage and Risk Before warmly embracing leverage as the magic answer to high yields, consider other risks. While increased amounts of financing can lead to enhanced returns through positive leverage, several less palatable destinations await the unwary. Few real estate investments can consistently tolerate high leverage ratios if sufficient cash flow is lacking to address debt service (mortgage payments). When faced with negative cash flow, the investor is forced to use capital reserves to offset deficiencies. Sometimes, this strategy reflects a conscious trade-off by an investor in the hopes of property value appreciation and a significant profit at point of sale. In other words, the buyer may tolerate negative cash flows while operating the property, but recoup such losses through the gain realized when the investment is sole. Consequently, financial pain may be short lived. However, investors may face a double whammy – a negative cash flow, followed by loss of value. If the loss is significant, the investor is also vulnerable to equity elimination i.e., the mortgage exceeds the value of the property. In market lingo, this is called being upside down on equity. If that is not enough, consider the impact of rising interest rates when the mortgage must be renegotiated during the investment holding period. Leverage increases the possibility of higher returns. However, as with all investments, higher returns usually translate into higher risks. TAXATION Cash flow and leverage aside, taxation is the third dominant factor in any investor’s decision-making process. When operations and sale proceeds cash flows are calculated, one final reality faces every investor: tax liability. Fortunately, real estate has always been viewed favourably given its tax sheltering capabilities. Tax Sheltering Tax sheltering is broadly viewed as any financial arrangement that results in the reduction or elimination of taxes due. A real estate investment opportunity is normally judged in terms of four characteristics: the reliability and durability of the income stream (operations cash flow), the opportunity to realize capital appreciation (sale proceeds cash flow), leverage possible to maximize return on investment and tax considerations that apply to that particular property. Taxation considerations include the analysis of tax shelter opportunities. Registrants should have general awareness of significant tax provisions in the Income Tax Act. For example, the Act provides for different tax treatment depending on whether a property is used for business/investment income or as a primary residence. While taxes are payable on the business and investment income, the principal residence is generally excluded from taxation under the Act. Further, the Act also distinguishes between business income and property income when rent is received by an investor from real estate. The differentiation of business income and property income is important as significant distinctions are made concerning the treatment of such income. Most importantly, the Income Tax Act provides for capital cost allowance (CCA) on income-producing property and generally reduces the taxes payable on operations cash flows, as well as impacting final sale proceeds at point of disposition. Cash Flow and Taxation Taxation liability impacts cash flows on investment rental property from two perspectives. An illustration is provided showing the impact of taxation on final return. The following description is for information only. Consult an appropriate tax expert on all such matters. Capital Cost Allowance Capital assets, though durable, have a limited lifetime and at some point will be replaced. Generally, the capital cost of a property is what the buyer pays for that property. Capital cost includes such items as delivery charges and PST. The Income Tax Act permits a deduction of part of the capital cost of the asset against the income from the business. Capital cost allowance (CCA) is the maximum rate set under the Income Tax Act that the taxpayer can claim for depreciation. CCA is not a cash flow item, but rather a matter of taxation and tax deductible expenses. CCA acknowledges the existence of depreciation that is the result of wear and tear over the life of an asset and the ability to offset income in relation to the cost of that asset.