Let’s talk about leverage. A lot of people don’t truly understand how leverage works, especially when it comes to real estate. In terms of real estate investing, leverage is using other people’s money to increase the return of your investment. The most common form of this borrowed money is banks, but can also include partners, private lenders, or equity in your home. Being able to utilize leverage is one of the main reasons you can achieve much higher returns with real estate compared to other investments.
I’ll start by using bank financing as the primary example to demonstrate how leverage works. Everyone knows that you can go to a bank and get a mortgage on a property. The most commonly known way of doing this is by putting 20% down and borrowing the remaining 80% to pay for the property. You also have the crowd that believes debt is bad and you should pay all cash for everything. This is essentially what you are doing when you are investing in stocks. When you buy stocks, you don’t have the power to use other people’s money to assist you in getting an asset you otherwise wouldn’t be able to if you had to pay all cash. This is where real estate investing really shines. By using other people’s money to help you acquire the asset, you greatly increase your return on investment.
First let’s demonstrate what kind of return you get when you invest with straight cash. Let’s say you are buying a $100,000 rental property that will rent for approximately $1,300 a month. If you pay all cash for the place you are all in for $100,000 and more than likely all of your available money went into buying this property. There will also be closing costs and other fees to buy it, but we will just use the purchase price to keep it simple. Let’s also assume property taxes, insurance, repairs, and maintenance on the property cost you about $500 a month. This leaves you with about $800 a month in cash flow that you put in your pocket. Multiply this by 12 months during the year and that leaves you with $9,600 profit at the end of the first year. Let’s also assume that the property appreciates $3,000 leaving you with $12,600 in total profit. To determine your cash on cash return, you divide the $12,600 profit by the $100,000 purchase price and that leaves you with a 12.6 % return on investment. Not a bad return right? Well let’s compare this to what you could have achieved if you utilized leverage to purchase it.
This example will assume you put 20% down on the property and you finance the remaining 80% from the bank. Instead of being $100,000 out of pocket to acquire the property, you are now only $20,000 out of pocket. You will have a mortgage expense in this scenario, but this is paid monthly spread out over 30 years at a low interest rate. The monthly P&I for the mortgage will deduct roughly $375 dollars from your cash flow every month. So instead of having $800 profit every month, you get $425 when accounting for the mortgage payment. Multiply this by 12 months and your yearly cash flow is $5,100. We will also assume the same $3,000 appreciation leaving you at $8,100 for the year. Dividing this $8,100 by the $20,000 you had to come up with to purchase the property, and your cash on cash return is now 40.5%!! This is a drastic difference for the exact same asset.
Not only is your return higher but you would still have enough money left over to buy 4 more $100,000 properties by putting 20% down on each of them. You can see how quickly that would accelerate your wealth over paying all cash for 1 property. These numbers are all purely a simplified example and this is not the only way to utilize leverage, but it really shows you the power of using leverage with the help of other people’s money. This is one aspect that make investment real estate really stand out from other forms of investments.
One could argue that using debt increases your risk, but if the asset is bought properly under market value, it is very smart to utilize leverage. When done properly and enough reserves are accounted for in case a big expense pops up, leverage is the way to go in real estate investing. Keep this in mind whenever you are considering whether to buy a property with all cash or to utilize some debt in the process.