Understanding Leverage
Leverage is a term that gets tossed around quite a bit when talking with Real Estate Investors. But what does it actually mean? Well, if you look it up in the dictionary, there are essentially two different definitions.
I think you can probably figure out which definition of the word we will be talking about. (Hint: it’s the one that talks about investing)
1. The exertion of force by means of a lever or an object used in the manner of a lever.
2. To use borrowed capital for (an investment), expecting the profits made to be greater than the interest payable.
Oxford Languages
What is Leverage?
At a very basic level, leverage in an investment is simply using borrowed money to increase the profits generated on an investment. Let’s start with an example to help show the power of leverage.
Suppose you can purchase an apartment building for $1,200,000. While there are many ways that you could get the money together to purchase the building, we are only going to look a 2 ways today. Either you could borrow money from the bank or you could pay the full amount in cash.
Borrow
- The bank borrows you 75% ($900,000)
- The apartment generates $20,000 in profits each year
- You invest $300,000
Pay in Cash
- Borrow NO money from the bank
- The apartment generates $20,000 in profits each year
- You invest $1,200,000
You might say, “well obviously everyone would borrow money because you don’t have to invest as much money”. Well, actually you are right, sometimes. The reason the borrowing option looks much more attractive is because it is utilizing Leverage. By borrowing 75% of the money, you are able to make a return based on the value of the building, $1,200,000, while only having to invest $300,000. That is what Leverage is.
Logically why wouldn’t investors use Leverage on every deal, all the time? Well, in order to borrow money from the bank, the bank wants to make sure that all the partners on the deal know what they are doing, have a good financial history, and would be able to cover large expenses, should they arise. (Think roof, water boilers, furnaces, that kinda thing) The bank will also want to know everything about the property to see if the income is high enough to cover all the expenses that the property will create.
Because the process of getting approval to borrow money from the bank can take a long time, sometimes investors will pay cash for a property to save time and close the deal sooner. Due to this, sometimes it is more advantageous to close on a property with cash.
Why is Leverage so powerful?
Let’s look at another part of the above example, that has to do with the profits each year. Notice, regardless of how much money is invested into the deal, it will still make the same profits each year. If we calculate the Cash on Cash Returns of each of the two options, you will start to see another reason why Leverage is so powerful! If you are unfamiliar with how Cash on Cash Returns work, click on the link and there is a whole post just explaining it.
Cash on Cash Returns are the Yearly Profit divided by the Total Investment. We can quickly see which of these options is most profitable. In the first example, our Cash on Cash Returns are 6.67% ($20,000 / $300,000). If we pay cash only for the building, our Cash on Cash Return would be 1.67% ($20,000 / $1,200,000)
Clearly, if we put less money down on the property, it will make larger return relative to the Total Investment. If we take this a step further, let’s say we put $50,000 down and purchase that same apartment for $1,200,000. Using the Cash on Cash Return formula, we would be getting a 40% Cash on Cash Return! That sounds amazing right!
Borrow
- The bank borrows you 96% ($1,150,000)
- The apartment generates $20,000 in profits each year
- You invest $50,000
This leads us perfectly into the dark side of leverage…
Over-Leverage
After the last example, logically, you would think that we should be borrowing as much as possible when purchasing a property. While that is true, all good things are best in moderation. There are 2 key things that we didn’t take into account on the last example, where we put $50,000 down on the property. The first is that your mortgage cost will go up, eating into the Yearly Profit, and second, the bank will often see the purchase as too risky.
What if the roof starts leaking, and it is discovered that the previous owner neglected to do proper maintenance on the roof. To replace the roof, would set you back $80,000! If you can’t afford fix it, and all the tenants move out, suddenly the property is producing no money and you are unable to pay the mortgage.
Then your problem becomes the banks problem, as they would repossess the building. This is the main reason why banks can take so long to approve financing on a building, because they must take every factor into account when assessing the risk involved.
Conclusion
Leverage can be a powerful tool in producing amazing Cash on Cash Returns for investors. When it is combined with proper due diligence, building analysis, and proper risk assessment, it is an incredibly valuable tool in building wealth.
