How investors are utilizing leverage to grow their real estate portfolio (BRRR method)
It’s no secret that the Canadian real estate market has built wealth for many investors in recent times. However with housing prices the way they are in major cities, it can seem daunting to build up a portfolio of properties, when even affording one can be a challenge.
It isn’t impossible for a retail investor to acquire a portfolio of multiple rental properties, but there may be other avenues of capital allocation which make more sense for your financial goals. With that in mind, let’s take a look at how some investors have been continually growing their real estate portfolio through the power of leverage.
- Some retail investors acquire a portfolio of properties through a repeated strategy of purchasing and leveraging equity.
- Over-leveraging comes with significant risks and can have major consequences.
- There are alternative ways to leverage real estate equity to achieve your financial goals.
The BRRR method is gaining popularity in real estate circles as a way to rapidly grow your property portfolio. It’s important to note however that leveraging can be risky if you don't know what you're doing. To learn more about how leveraged investing works and how to use it effectively, read our introductory guide to leveraged investing.
Most Canadians are already using leverage to help purchase their home. A mortgage is one of the most common forms of leverage used by investors to build their real estate portfolio. By putting down your typical 20% in cash and borrowing the rest, you can build equity over time and later down the line access cheap leverage by borrowing against the equity in your property.
What is the BRRR method?
The “BRRR method” refers to a recently popularized strategy of purchasing property and then borrowing against the equity of previous properties to fund the purchase of more rental units.
An investor using the “BRRR method” would purchase a rental property, start generating income from it to pay for the mortgage, and then shortly after, access financing by borrowing against the equity in the property to fund the down payment of their next investment property.
This method of continually purchasing properties by accessing leverage through the previous ones has been used to quickly accumulate multiple investment properties by some investors, however if things go wrong, the consequences of being over-leveraged could be disastrous.
Why the "BRRR method" can be risky for real estate investors
Real estate investing can be highly lucrative, and the "BRRR method" has gained popularity among investors due to its potential for fast accumulation of multiple properties. Before you try and implement this strategy yourself, let’s take a look at how things could go wrong.
The "BRRR method" relies on rental income from properties to cover the mortgage payments on future properties. While this can work well in a stable market, a downturn could quickly lead to significant losses. If the rental market faces a downturn, you may find yourself unable to cover mortgage payments, forcing you to sell off assets. Even worse, a decline in property values could leave you underwater on your mortgages and leave you with massive losses in the event you need to sell them earlier than you were expecting.
Over-leveraging with the "BRRR method" can be a recipe for disaster if you don't carefully consider the risks and create a plan that ensures you won't over-leverage beyond your means if things go wrong. It’s essential to approach this method with caution and avoid taking on too much debt.
The risks of over-leveraging
While it can be tempting to borrow capital whenever you have access to it to fund the purchase of assets, over-leveraging is never a good idea. While using leverage to invest in low risk assets like GICs can mathematically be sound, when you introduce volatility into the mix it’s a whole different story.
The primary danger with leverage is the event that your investments yield less than the cost of borrowing and you end up needing to pay interest without any profit to do so. The key to avoid over-leveraging yourself is to make sure you’ve planned for the situation that your assets don’t return what you’d hoped and you have other income to pay for the cost of borrowing. If you’ve borrowed more than you can afford to repay in the event your investments don’t turn out as planned, the worst case scenario is bankruptcy.
Most common risks associated with over-leveraging your portfolio
- Magnified losses: If your leveraged investments depreciate and you sell them at a loss, you’ll still need to pay off the loan with interest, meaning you’ve lost more than you would have investing in the asset with non-borrowed capital. If this happens you may have to liquidate your other assets to make up for the loss.
- Poor cash flow: If you’re investing in assets which don’t generate more income than the interest payments of the loan, you’ll end up with worse cash flow than you would have otherwise. You could be left paying interest on the borrowed capital without income to offset it.
- Maturity risk: Depending on the conditions of your loan, your lender may demand early repayment under specific circumstances. If this happens during a time when your investments are down, you may need to sell at the wrong time and realize losses that could have been avoided.
Alternatives to grow your portfolio
While the “BRRR method” focuses on using massive amounts of leverage to rapidly grow a portfolio of rental properties, there are of course many other ways you can use leverage to reach your financial goals. Rather than borrowing equity from your property to invest in more real estate, you might want to consider using something like a HELOC to diversify your portfolio.
As a general rule, using leverage is beneficial when the expected returns from an investment exceed the cost of borrowing capital. For example, if you can borrow equity from your home at an interest rate of 4.00% annually to invest in a guaranteed 5.00% returning GIC, you’ll be profiting the difference of 1% with limited risk as GIC’s are guaranteed.
However, keep in mind that high-volatility investments may carry significant risks, leaving you paying more interest than you can handle to hold on to your depreciated assets. When utilizing leverage it might be a better idea to consider less volatile, income-generating assets, such as bonds, dividend funds, and mortgage funds. These assets come with potentially less risk premium when compared to other assets like equities.
Perch Capital is an example of a mortgage fund which offers a 9% targeted annual return rate and could potentially represent a great opportunity for an investor to acquire an income generating asset while still having exposure to the Canadian real estate market.
Safely utilizing leverage to grow your portfolio
Let’s imagine you’re nearing retirement with a paid-off home valued at $1,000,000. You talk to your mortgage advisor and find out you qualify for a HELOC of up to $800,000 at 4.50%.
You have enough liquid assets that you can afford to pay some of the interest payments, even if your investments are volatile in the short-term. You’ve heard of a mortgage investment fund that is advertising 9.00% returns with a minimum investment of $50,000. You decide to borrow $500,000 in the form of a HELOC, invest in the mortgage investment fund and net around $22,500 annually. You’ve now leveraged your home equity to generate passive income with minimal effort and lower risk than a volatile asset like equities.