Mortgage rates are falling as central banks in the United States and Europe have reduced interest rates to near zero levels. According to the Mortgage Bankers Association (MBA) Weekly Mortgage Applications Survey for the week ending March 27, 2009, the average contract interest rate for 30-year fixed-rate mortgages in the United States dropped to 4.61 percent from 4.63 percent, for loans with an 80 percent loan-to-value (LTV) ratio. The contract rate is a 19-year record low for the survey, which started in 1990.
Property investors can benefit from low mortgage rates, if they can find deals that allow for positive leverage. The term positive leverage is used to describe the case in which the use of borrowed funds enhances the return of a property investment, compared to the return that it can be achieved without using borrowed funds. Notice that using borrowed funds or debt (as otherwise referred to) to finance a property investment does not always enhance investment returns. The use of borrowed funds can have and a negative effect on property investment returns, if certain conditions are not met.
A simple technique to determine whether the use of borrowed funds in financing a property acquisition will increase the return on the capital that the investor will put from his own pocket (this is referred to as equity) is to compare the rate of return on total capital with the mortgage constant of the particular loan that is considered for financing the acquisition.
The return on total capital, which is also referred to in real estate investment textbooks as the free and clear return or overall rate, actually represents the net operating income (NOI) of the property as percentage of the total capital investment (both equity and debt). As such, it is calculated as the ratio of the NOI over the total capital invested.
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 annual mortgage constant represents the required annual loan payments as a percent of the total loan amount.
The mortgage constant for a particular loan depends on the mortgage rate, the term of the loan, and the loan amount. Thus, lower mortgage rates mean and lower mortgage constant (keeping the loan amount and the term of the loan constant). Notice that 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 return on total capital with the mortgage constant is a simplistic technique and has deficiencies, since NOI may fluctuate over the holding period of the investment and potential capital gains or losses are ignored. Furthermore, the potential impact of income taxes on investor return are not take into account since NOI is a before-tax cash flow measure. For this reason, a complete discounted cash flow analysis of the property investment under consideration is needed to accurately evaluate whether the use of a particular debt financing will enhance investment returns.
Credit conditions currently are very tight and banks screen very thoroughly mortgage applications. However, if property investors can secure financing in favourable terms that will result in positive leverage they will be able to further boost their investment returns. However, despite the attractive mortgage rates, extra caution is needed in the current deteriorating environment so that potential decreases in NOI and property values are properly taken into account in assessing whether the use of debt will indeed result in positive leverage.
Dr. Petros Sivitanides, the author of Real Estate Investing for Double-Digit Returns, has a Ph.D. from M.I.T. and over 17 years of experience in real estate investment consulting, research and forecasting. More on mortgage loans and property investing can be found here.
[tags]mortgage rates,mortgage loans,mortgage financing,mortgages,property loans,property investments[/tags]
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