130: Leverage – Friday Fundamentals

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Leverage is an important tool, especially in real estate investing. It’s perhaps the most distinguishing characteristic from other asset classes (paper assets – stocks, bonds, mutual funds, etc. and alternative assets – oil and gas, art, agriculture). That is, leverage is a common practice in today’s real estate world. Without it, we wouldn’t have near the quality nor quantity of homes, apartments, high rise office buildings, warehouses, or retail stores as we do today.

By definition, leverage is using borrowed capital for an investment, expecting the profits made to be greater than the interest payable.

Many real estate investors use leverage to buy properties, by borrowing money from banks, credit unions, and private lenders. There are some people who prefer not to use leverage though. These people consider leverage a risk, and prefer to buy properties with all cash, or pay off loans quicker than required by making extra mortgage payments. A person who doesn’t use leverage is most likely doing so to avoid or reduce risk. They associate debt with risk. But is this person really reducing their risk. Let’s take a deeper look.

Let’s say there are two investors who both buy 2 houses next door to each other. Both are $100,000. Investor A pays all cash for the property. Investor B pays a 20% down payment and borrows the rest. Both of their houses appreciate 4% in the first year, now both valued at $104,000. Investor A, who paid all cash, has a 4% return on his money. Investor B, who only paid a $20,000 down payment, realizes a return of $4,000/$20,000 = 20% on her money.

This scenario shows how leverage magnifies returns. Note that equity had nothing to do with the returns. Both properties appreciated 4%, independent of equity. But what about risk? What if these homes decrease in value by 20%, and are now worth $80,000. That’s a $20,000 loss for both investors.

As Keith Weinhold says, equity has a rate or return of 0. It can only go down in value. It will not go up. So how much equity would you want, if it can only go down, and not up? I personally wouldn’t want any of it.

By reducing your equity position in a property, you have less of your money exposed to market conditions. If you are sued, there is less money to go after. In the event you have an insurance claim and the insurance company doesn’t want to pay your claim, guess who is on your side? Your partner, the bank. Remember, when you have a low equity position, you have less skin in the game. Conversely, the bank has a lot of skin in the game. Therefore the bank has an interest in your insurance claim too.

Leverage isn’t all bad, like some want to make it. Used wisely, leverage can allow you to grow your portfolio much quicker, reduce your risk, and magnify your returns.

Leverage though, can magnify losses just as it does returns, so it’s important to invest wisely. If you haven’t yet used leverage to buy a rental property, I recommend you go back and take a listen to Ep. 127 with John Matheson. He provides a ton of great resources on preparing your project and yourself for a loan with the bank. This is a critical piece to your real estate investing journey, and you should treat it like such.

 

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