THE MAGIC OF LEVERAGE
5 ways of using this magical power to increase the return on your investment
What if you could “magically” turn a simple 3% rise in the value of your investment into an actual 12% return on your investment?
You might be able to and it is not magic.
The 170-pound guy in the picture above is using a jack to lift a sixteen hundred-pound race car. The secret is leverage.
Investors like you can also use leverage to lift your returns.
Want to hear more?
In the investment world leverage is using someone else’s capital to multiply the power of your own personal capital. This could be from a bank or from a private partner in the form of a loan.
When most of us bought our homes we made a down payment and borrowed the rest of the cost of the home from a bank.
We had a little bit of money and were able to buy something that cost a lot more than the amount of money we originally paid for it.
Let’s say you bought a rental house for $100,000 and made a down payment of $20,000 and borrowed the rest ($80,000) from the bank. Your ability to get a loan or mortgage on rental property provides this powerful leverage tool.
Now, of course, some other investment vehicles offer the possibility of using leverage. For example, buying stocks or mutual funds on margin, or a loan from your investment firm.
The loan creates leverage. Do you see the word “lever” in the word “leverage”?
THE TEETER-TOTTER ON THE PLAYGROUND
You might remember from your elementary school days that a lever is one of the five basic simple machines, along with the screw, wheel and axle, incline plane, and wedge. Levers and the other simple machines help us do more work with less effort.
Examples of levers include: the car jack in the picture, a pry bar, pliers, scissors, wheelbarrow, your arm, a baseball bat, or golf club.
The teacher in my school pointed out the window at the teeter-totter or seesaw on the playground. “That is a lever,” she said. A small kid way out on the end of one side could lift a big kid way far in on the other side. That little kid could use the lever (teeter-totter) to lift the bigger kid.
Similarly, the mortgage on a house or an apartment complex allows us to use a little bit of capital leveraged with a larger loan to purchase the property at a much higher price that would be possible with just a little bit of capital.
This is the first of the five ways of using leverage.
FIRST: BUY MORE WHEN YOU DON’T HAVE ENOUGH CASH
When you don’t have enough cash to purchase a property but use the ability to borrow additional money you are using leverage.
Small investors can play on bigger playing fields when they can obtain loans for the purchase of properties.
For example, let’s say you and some other investors pool $1 million dollars together and purchase an apartment complex. Without leverage of a loan, the most you would be able to afford would be a $1 million property. At $100,000 a door purchase price, this would limit you to a 10 unit property at best.
But, if you are able use your $1 million as a down payment and secure a mortgage for $4 million, you would be able to buy a $5 million property, or a 50 unit apartment complex.
That is the first powerful way of using leverage. But, there is more.
SECOND: ARBITRAGE THE INTEREST RATE SPREAD, WHEN THE INTEREST ON THE LOAN IS LESS THAN THE RETURN ON THE PROPERTY
A second way you can use leverage is if the interest you are paying on the loan is less than the return you are getting on the property. This is a spread in your favor. You are paying less for the money than you are making on it. Some call this arbitrage.
Joe bought a property by using a 30 year mortgage which had an amortized loan at a 4% interest rate. The net income on his property was producing an 8% return on his investment from the rental income he was receiving from the tenants, before paying the mortgage. There is a 4% positive difference in what is going out in interest paid and what is coming in in net income.
Thus a little additional benefit of leverage occurs when the interest rates are lower than the net percentage return on the property each year.
This is the second way to employ leverage wisely.
THIRD: INCREASE YOUR CASH ON CASH RETURNS
Leverage will also potentially increase your cash-on-cash returns.
If you used all cash and bought the $1 million 10 unit property and you were able to net $100,000 of income each year, you would be receiving a 10% cash on cash return annually from the cash flow of the property. Not bad.
But, if you leveraged with a loan of $4 million on a 50 unit complex, you might receive a net income of $500,000 annually. Now, of course this does not account for the added cost of the interest on the loan which might reduce your net income down to $200,000. So your $1 million is now generating a 20% ROI annual cash on cash return on investment in terms of cash flow. Even nicer.
This is the third way to put leverage to work for you.
FOURTH: BUILD YOUR EQUITY FASTER
A fourth way and perhaps the most powerful is to potentially use leverage to grow your equity faster than if you had used all cash for the purchase.
This assumes the value of the property is appreciating over time. In other words, you could sell the property at a higher price than you what you paid to buy it. Buy low and sell high is always a good rule for investing, particularly with leveraged real estate.
Most of us who have owned our own homes have employed this power of leverage.
Let’s say we put 20% down on a house that costs $100,000. We borrow $80,000 from the bank. This would mean we had $20,000 invested in the house. The smaller amount ($20,000) was able to lift the larger purchase ($100,000) by borrowing the balance and then paying off the balance of the loan over time.
If that house increased in value by $20,000, that would be a 20% increase on the $100,000 purchase price. But, remember, we only have $20,000 of our capital invested in the property. So the $20,000 increase in our equity would actually be a 100% return on our invested capital at the sale.
Leverage has multiplied our return, the growth of our capital.
This is true because all we owe to the bank is what we borrowed from them. Any increase in the “bank’s share” comes to us. We pay back the $80,000 loan, get our $20,000 returned to us, and keep the full $20,000 increase in the value of the property. Wow, look at the potential power of leverage.
We’ll look at the fifth way of using leverage in a bit. First, be aware that leverage can work both ways. The use of leverage can be quite powerful as you can see, but the reverse is also true. Leverage is like a magnifying glass. It will magnify any gains. And it will magnify any losses, too.
CAUTION: UPSIDE AND DOWNSIDE POTENTIAL WITH LEVERAGE
If instead of going up in value over time, the property we purchased goes down in value, we can have greater losses than if we had used all cash for the purchase. The leverage will have magnified the loss.
Bill bought a house at the peak of the market in 2008. He put down $5,000 and borrowed $95,000 from the bank for the purchase of the $100,000 property, hoping it would continue to go up in value. But, it didn’t. The residential real estate market crashed and the value of the property dropped and dropped some more. Eventually the prices stabilized at $50,000.
Bill still owned the bank the full $95,000. If he had to sell at this price, he would have to bring an additional $45,000 to the closing table, a loss of $50,000 total, a net loss of $45,000. Ouch.
Leverage can work both ways.
With our real estate investments we mitigate this risk by using loans wisely, not getting over-leveraged. We also exercise a great deal of control over the property through buying right, financing right, managing right, and exiting our investments right.
FIFTH: IF YOU HAVE ENOUGH TO PURCHASE ALL CASH, BUY MORE PROPERTIES INSTEAD
A fifth way of using leverage is using your available cash to buy more properties.
Suzette had the full $100,000 in cash from the proceeds from her parent’s estate. She could buy one $100,000 rental property with this or she could buy five $100,000 houses with it, if she were able to borrow the additional money for the purchase.
Look at this very powerful way of using “other people’s money” or leverage instead of only using your own money.
One $100,000 property might produce $5000 in net annual income or a return of 5% cash on cash. Five $100,000 properties might produce $25,000 in net annual income or a return of 25% cash on cash.
And the equity would build proportionately as well. Win, win, win all around.
Hopefully you can see the magical power of equity with real estate investments. And you will realize this benefit is not easily employed with other investments like savings accounts or stocks and mutual funds or gold or most traditional investment instruments.
Leverage is the L among the five benefits of real estate investments. They five spell the word IDEAL. I is the income produced. D is for the tax benefit of depreciation. E is the growth of equity primarily through appreciation. A is amortization available because of the ability to get long-term mortgages. And the L is leverage.
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