We double our returns by using conservative leverage.
A lot of investors know how leverage works, but even some sophisticated investors don’t always get it completely. If you haven’t used it much, or had investments that use it, then the concept of leverage can be a little fuzzy.
Leverage is a double edged sword. It works to increase your return but, it can also put you at risk with your investment. However, leverage and real estate go together very well, especially when used judicially.
One of the most common reasons leverage is used in real estate is because it is hard to buy a rental home for $50,000, but you can if you use leverage. Secondly, for investors that are looking to maximize their returns, leverage is a powerful tool.
In addition, it is usually easier to get leverage for real estate than for other investments. This is because lenders understand real estate (most of the time), it is usually an income producing asset, and real estate investments should continue to produce cash flow, even in down markets.
There are a lot of generalities and assumptions in those last two sentences but I think you get the picture. Let’s do some simple math to illustrate the power of leverage for a single family home.
No Leverage (cash purchase)
Purchase Price $200,000
NOI (net operating income) $20,000
Annual Return w/o Leverage 10% ($20,000/$200,000)
Use of Leverage
Borrow (75% LTV) $150,000
Equity (25% down payment) $50,000
Debt Service on Leverage ($10,000)
NOI after Debt Service $10,000
Annual Return w/ Leverage 20% ($10,000/$50,000)
Now let’s take that a couple of steps further. For the investor that has $200,000, he could buy four homes instead of one and produce $40,000 a year in cash flow. Over a 30 year investing career, that adds up to serious money.
30 Years at $20,000 = $600,000
30 Years at $40,000 = $1,200,000
That is not even taking into consideration the effects of compounding that money over the 30 years which would widen the gap dramatically between the two returns. The risk comes if the property doesn’t produce enough cash flow to cover its debt service. To mitigate that risk, always make sure you have back-up cash to service the debt for a period of time.
With our real estate fund, we are never over 75% leverage. We have never, to this day, even been close to that. Most of the time we are at 50% to 55% and without leverage our returns would be lower. Plus we would have helped 50% less families achieve their dream of homeownership.
Leverage can be a beautiful thing when used wisely.