LEVERAGE FOR LACK OF A BETTER WORD IS GOOD!
In the 1987 movie, Wall Street, actor Michael Douglas as Gordon Gekko, said, “Greed, for lack of a better word, is good.” The reality is greed wrecked our economy causing the 2008 Real Estate and Stock Market recession! Greed may put some Kodak Company executives in prison for alleged insider stock trading. So, let’s replace the word greed with LEVERAGE.
Leverage/Debt is a powerful tool, when SMARTLY utilized in real estate investments and is GOOD.
WHEN TO USE LEVEARGE
Leverage allows you to utilize other people’s money (DEBT) to achieve a bigger return on your dollars. If invested in assets that produce a high enough return to pay off the debt/mortgage and the asset is appreciating in value at or greater than inflation, using leverage is an excellent investment! By doing your due diligence, rental properties achieve both objectives.
Using leverage works when the property’s value and rents are steadily increasing. The property appreciation must keep up with inflation and hopefully exceed inflation.
Due to inflation, fixed cost such as taxes, insurance and maintenance will increase most years. If the property value and rent are only slowly increasing or worse declining, the advantages of using leverage will quickly be lost.
USING LEVEAGE VERSUS YOUR OWN MONEY
Let’s look at two examples, one with leverage and one without. In both examples you buy a $250,000 rental property.
- Example #1: You put 20% down and finance the balance with a 30 or less year loan @ ~4.5 percent.
- Example #2: You pay cash – ZERO DEBT.
Look at below table and decide which example provides a better return?
| PURCHASE PRICE | DOWN
PAYMENT
|
INTERNAL RATE OF RETURN (IRR)
|
CASH ON
CASH RETURN |
PROFIT WHEN SOLD IN 20 YEARS | |
| #1 {See Appendix #1} | $ 250,000.00
|
20% =
$50,000.00 |
16.38% | 845.51% | $448,119.00 |
| #2 {See Appendix #2} | $ 250,000.00
|
100%
$250,000.00 |
9.02% | 232.85% | $589,107.00 |
Internal Rate of Return (IRR) Internal rate of return (IRR) or annualized total return is an annual rate earned on each dollar invested for the period it is invested. The higher the IRR, the more desirable the investment. The IRR for the 20% down payment option ties up $50,000 cash and therefore the return is higher versus paying the entire $250,000 and forgoing a mortgage. Option #1 is better
Cash Flow Return on Investment When purchasing rental properties with loans, cash flows need to be examined carefully. Rental property investment failures can be caused by unsustainable, negative cash flows. Cash Flow Return on Investment (CFROI) is a metric for this. Sometimes called Cash-on- Cash Return, CFROI helps investors identify the losses/gains associated with ongoing cash flows. Sustainable rental properties should generally have increasing annual CFROI percentages, usually due to static mortgage payments along with rent incomes that appreciate over time. Option #1 is MUCH better
If you simply look at the profit after 20 years, it appears Example #2 was the better deal. But look at cash on cash return. By utlizing $1.0 MILLION leverage with your $250,000 cash, you can invest in five similarly valued properties, putting down $50,000 each and financing the remaining balances. In 20 years, your profit would equal, $448,119.00 x 5 = ~$2,240,600.00. Compared to a profit in 20 years of $589,107.00, if you paid cash.
This is the power of leverage when coupled with an appreciating asset!
DIVERSIFICATION FOR YOUR OWN SAFETY
You should NEVER invest in one class of assets. Your investments MUST be diversified across multiple assets, such as real estate, stocks, precious metals, bonds, ETF’s etc.
CONCLUSION
Financing a property with leverage can be a good long-term investment strategy. Holding onto your leveraged property long-term can produce excellent returns, and monthly cash flow as well.
For leveraged investors, there are two important practices to achieve optimal success:
-
Perform comprehensive due diligence, PRIOR to buying a property.
-
Develop a smart investment strategy, with rules. Follow your rules!
PREVIOUS APPLICABLE BLOGS
2020 WAS THE RIGHT TIME TO INCREASE MY REAL ESTATE PORTFOLIO BY $1 MILLION
APPENDIX 1.0: 20% DOWNPAYMENT
APPENDIX 2.0: ZERO LOAN
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I am a proud nerd (as my beautiful wife and daughter have told me) investment and finance blogger, with a NC State, Chemical Engineering, University Rutgers, MBA and Harvard University, Advanced Management education.
I left a corporate career because I had a desire for making a difference as a speaker and writer, to help others. I was blessed to be coached and mentored by strong women and men in both my family and professional life. It is my time to serve and give back.
DISCLAIMER
I started my first business at ~13 years of age (small but brilliantly created plant nursery). I am a successful investor in stocks, options, real estate and happy to share my personal finance and investment lessons learned with you.
However, I am NOT a licensed financial advisor. Please do not construe my suggestions on this blog, as recommendations for your personal situation. For individual finance advice please seek your own licensed CPA or fiduciary financial advisors.
I write this weekly blog to make an impact by reaching an audience and demonstrating the need for financial literacy. I will help you get there.
Thanks for sharing this article on leverage. I found it to be very thorough and informative. Looks like this is something you love doing, that is managing leverage and making money for investors and of course the entrepreneur!!! Good reading and much appreciated, my friend.
Thank you Haves. Hope you and your family are well.