253: Leverage – Friday Fundamentals

Leverage Leverage is a powerful tool. It can come in many different forms, from the mechanical leverage of a seesaw to the financial leverage of a real estate loan. We’re constantly using leverage in some form or another. Leverage defined is: use (something) to maximum advantage. use borrowed capital for (an investment), expecting the profits made to be greater than the interest payable. Financial leverage is simply borrowing money to invest, with the expectation of making a profit. Leverage, in the context of real estate investing, is debt. We’ve been conditioned to view debt as a negative thing, and rightfully so. But not all debt is created equal. There is good debt (the kind that others pay for you) and then there is bad debt (the kind you have to pay yourself). Leverage is an area where many real estate investors struggle because it can be counterintuitive in the sense that real estate debt can and usually is a good thing. Let’s look at how that can be true. Leverage magnifies your return on investment, both positive and negative returns. Let’s look into some investing metrics here. Two important metrics are Cash on Cash Return (CoC) and return on equity (ROE). Let’s take a duplex for example. This duplex purchase price is $100,000, and rents for $500/unit per month for a total of $1,00o total rents per month.  One of the most important things we consider as real estate investors is the bottom line cash flow number – that is how much does the property profit per month, after paying all the expenses from the rental income. There are two ways we can look at this example: Scenario 1. We buy the property without leverage, and pay all cash for it. Scenario 2. We buy the property with leverage, by borrowing money from a bank and putting down 20% of the purchase price which is $20,000. Let’s look at Scenario 1 where we do not use leverage. The monthly break down looks like this: 1,000 in monthly rents – $400 in expenses (Vacancy, Insurance, Maintenance, Taxes, Utilities, Management) = $600 per month in positive cash flow Now let’s look at Scenario 2 where we use leverage and put down 20%. Our loan for the remaining 80% is a 30 year fixed rate with a 4% interest rate. 1,000 in monthly rents – $400 in expenses (Vacancy, Insurance, Maintenance, Taxes, Utilities, Management) – $382 for the mortgage (principal and interest) = $218 per month in positive cash flow At first glance, you might look at the $600/mo. cash flow of scenario 1 as outweighing the $218/mo. cash flow in scenario 2. But let’s compare the important Cash on Cash returns. Scenario 1: We paid $100,000 for the property in cash. The property makes $600/mo., which equals $7,200/year. $7,200/$100,000 = 7.2% Cash on Cash return. Scenario 2: We put $20,000 down for the property and it makes $218/mo., which equals $2,616/year. $2,616/$20,000 = 13% Cash on Cash return. That other important metric we mentioned is the Return on Equity, or ROE. Let’s calculate the ROE of each scenario. In both examples our $100,000 duplex appreciates 5% over 1 year. Scenario 1 (no leverage): After one year our property is now worth 5% more, or $105,000. We made $5,000 from the appreciation of our property. This...