Maximizing Leverage with Net Annual Constant

When investing in residential real estate there are many things that make up the overall benefit of the investment. Cashflow, value appreciation, tax depreciation and tax deductibility are a few that comes to mind. Another important element is leverage. How much or your capital is tied up in the investment and what is your monthly after-tax cashflow?

I was reminded of something I read in one of John T Reeds books a long time ago called the Net Annual Constant. It may have been in “Aggressive Tax Avoidance for Real Estate Investors” (which was and is fantastic), but nevertheless I went to his website and he explains Net Annual Constant as follows:

The annual constant is the mortgage payment divided by the loan balance. This goes up every month in a long-term, fixed-rate, self-amortizing mortgage, which is the most common type of mortgage. Since only the interest portion of it is deductible, the rise in this reduces after tax cash flow geometrically over time.

Refinancing knocks the mortgage payment back down as a percentage of the loan amount. Exchanging the property tax free and acquiring another also has the effect of keeping your loan-to-value ratio high (leverage which multiplies return on equity) and your after-tax cash flow higher because almost all of the mortgage payment is deductible.

Basically, to maximize your return on equity, you need to keep your loan-to value ratio high. Over time the loan to value ratio will decrease (as more and more of your payment goes towards the principal.) Paying off a mortgage may be desirable if your main goal is to own a property free and clear (and then live off the rent income.)  On the other hand, if you want to amass more properties, doing regular refinances may reduce your monthly payments and increase the potentially deductible mortgage interest portion (by stretching the payments out over 30 years again.)

By regularly refinancing your investment properties you will very likely end up paying more mortgage interest in total on the property.

However, assuming the refinanced interest rate isn’t significantly higher:

• The lower mortgage payment could/should increase your rate of return on the invested capital
• The after tax cash flow could/should be improved, as more of the mortgage payment is tax deductible
• Resetting the loan term to 30 years could/should lower your monthly payments and increase your ability to obtain additional financing for other properties.
• Buying more properties and reducing the equity in your overall investment portfolio could/should increase your overall wealth creation.

The tax deductibility of a real estate investment will vary from person to person – I am not a tax expert. Always consult a real estate tax expert before making a real estate investment property decision.

We routinely help real estate investors buy, lease, sell and manage homes in the Northern Virginia area. Call or email us to discuss your thoughts and plans.