204: The Power of Leverage

SHOW NOTES FOR EPISODE 204: THE POWER OF LEVERAGE

Real estate investing has many great attributes but one of its greatest is the ability to create massive wealth through leverage.  In this episode, Bill will explore the power of leverage in real estate investing and share how you can exponentially grow your investment dollar by utilizing this valuable strategic tool.

Introduction

Real estate is by far my favorite asset class.  Even though I’ve been tempted to sell my rental properties at times due to some of the headaches associated with rental properties (if you heard last week’s podcast, you’ll know what I’m talking about), I still think real estate is the best investment category out there. And, the tax benefits aren’t bad either.

A deep dive assessment of all my assets shows that real estate has provided the highest return on capital invested with the least amount of stress. I have invested in stocks and have done pretty well.  However, when I was younger, I was more apt to take investment risks.  Not today.   The last thing I want to do is use my risk-free money to invest in stocks. I absolutely hate losing money – been there, done that.  As an Old Dawg, I want to hold on to what I’ve earned and saved and want to make wise decisions, carefully invest and leverage it for maximum returns… as safely as possible.

That’s why I think it’s important to discuss leverage.  This is one of the most beautiful aspects of real estate investing – and yet, you still need to be careful and wise and make sure you don’t over-leverage yourself at the same time.

Leverage is the ability to take a little (or sometimes even nothing at all) and use it for maximum advantage to produce significant returns.

What is Leverage?

• Doing more with less
• Acquiring investment property using other people’s money (OPM- banks, private investors, owner/seller financing, etc.)
• It’s “Forced equity” through renovations, reduced expenses, increased income, property management
• Tapping into equity to increase holdings
• Creating systems that better “manage” and optimize income

Different Types of Leverage

• Using Other People’s Money

  • This is the most common type of leverage that most people are familiar with.. It is associated with mortgage down payments – where you are able to buy a property for, let’s say for $100,000, by putting a small percentage of cash down of, let’s say, $20,000 or 20%, where the bank or mortgage company carries the rest of the balance while you make monthly payments (of let’s say $492 at current rates of 4.18%) over a 30-year period.

• Leveraging Rental Income

• Accelerated Loan Pay-off/Pay-Down

  • This is often used by people who are working a full-time job, who don’t yet need the cash flow who want to reduce their loan obligation and build equity before they are retired.
    • For example, if you buy a property for $200,000 and rent it for $1,700 per month or $20,400 per year, you would be getting 10 percent of the home value in cash flow if you spread the mortgage out over 30 years. On a home loan with a 4.5 percent interest rate, your principal would be around $1,013 per month.  Adding estimated taxes and insurance would bring your mortgage payment up to around $1,300. Therefore, you would have an extra $400 a month or $4,800 of cash flow per year in liquid income, that you could direct apply  to mortgage principal  to accelerate paying of the mortgage payment .
    • Assuming you have positive cash flow every month, you can then leverage that liquid income to pay off the mortgage more quickly. Using the same theoretical example, if you put that extra $4,800 toward your principal every year, you could have your mortgage paid off 13 years sooner and save a whopping $76,698 in interest. This is because the more you pay on your principal, the less tax you have to pay over time.

• Savings

  • Save your rental income and use your savings to acquire more rental properties

• Property Improvement

  • You could use the property income to improve properties to:
    • Add Value
    • Force equity (especially with commercial properties)

• Diversify

  • Invest that income in other cash flowing non-real estate investments: (index funds, a business start-up, etc.)

How Does Leverage Work?

To understand how leverage works very best, let’s look at the example of four people who have $100,000 to invest in real estate.  I actually explore this in more detail in podcast #090 – If I had $100,000 to invest in real estate.

Let’s explore how you can use leverage 4 different ways here, using an investment amount of $100,000:

1. Buy With Cash

• Person A bought a $100,000 investment property will all cash.  After taxes, insurance, and property management fees, the property generated a cash flow of $500 a month.  At the end of the first year, Person A will have made earned $6,000 in cash flow income, a 6% return on investment.  Not bad!

2. Put 20% Down/Carry Mortgages on Multiple Properties

• Person B – Instead of buying one property, Person B invests $20,000 into five different investment properties (of course, to simplify the example, we’re not including closing costs). After mortgage payments, taxes, insurance and property management fees, each property generates a cash flow of $200 a month per house or $1,000 a month in net cash flow.  At the end of the year one, Person B will have made earned $12,000 – or a 12% return on investment. Even better!
  • Not only is Person B making more money than Person A but he or she also controls $500,000 worth of real estate, compared to only $100,000, which means there are more opportunities for home value appreciation, big tax savings and lower risk since Person B is better diversified with five different rental properties.
  • The more homes/doors you own, the more diversified you become.  Owning only one unoccupied rental home when, let’s say, super storm Sandy floods your house means $0 cash flow and $0 income, whereas the chances of 5 homes all being damaged in the same way is much less likely.
  • With five rental homes or doors and one unoccupied, that’s only a 20% vacancy.  The four others will provide an income buffer for you until you can get the damaged home repaired and rented out again.  Also, you can diversify by picking different neighborhoods, different sized homes or different renter types.

3. Invest in a REIT

• Person C invested all $100,000 into let’s say the Vanguard REIT (VNQ), however, the stock market was flat for this example year and they earned only 3.30% in dividends.  At the end of the year, Person C made $3,300, a 3.30% return on investment.
  • You could say Person C had the lowest risk of all since he or she was diversified into hundreds of real estate holdings inside the REIT but Person C  also had no control over how and what the REIT invested in, what rent to charge, and who they rented to.  The advantage Person C had was the liquidity of his or her investment.
  • If he or she needs her money out now she simply sells her shares. In a few days, the money is there. With real estate properties, selling an investment property or taking out a loan to draw equity out is a longer process.
  • Now, because I love multifamily, I’m adding a Person D

4. 20% Down Payment/Carry Mortgage on One Multifamily Property

• Person D takes $87,000 (of the $100,000) and uses it for a down payment on an off-market multifamily property that has below-market rents.  The property is a $440,000 8-unit apartment in Orlando, Florida (this is an actual apartment that recently sold).  And Person D uses the remaining $13,000 (of the $100,000) to do a light renovation of the apartment.  The apartment building, before rehab, brings in $6,600 in monthly rental income or $79,200 annually.  But, with the light upgrades, Person D is able to increase rents 10%, thereby increasing income to $7,260 or $87,120 annually.  The monthly mortgage payment is $2,400 monthly and other expenses (using the 50% rule) bring the monthly cash flow to $3,630 or an annual cash flow of $43,360.  That’s nearly 30% higher than Person B who bought 5 houses.
  • In addition, Person D, for example could introduce a RUBS program (Ratio Utility Billing System) thereby reducing expenses even further.  Now, here is where you see leverage at its best.  As a commercial property, Person D can force appreciation.  With, increased rent and reduced expenses, the new ROI increases and results in an equity increase of $100,000 in the first year.  Person D can now do a cash-out re-fi, taking the $100,000 equity out and buying another apartment building.  If he’s getting the same returns on the second apartment building, he’s now cash flowing over $86,000 a year – all from his or her original $100,000 investment – a 86% return-on-investment.

Summary

You see, there are no investments I know of, besides real estate where you can do this.

The key here is to find your personal balance between leverage and your tolerance for debt.  You need to be wise, be aware of the economy, get the right rate and terms and give yourself enough buffer to handle economic changes.

There are investors out there who have hundreds of homes/doors in their portfolios and are all highly leveraged.  Others balance risk by saving up to buy the next property while at the same time adding extra payments to their highest interest mortgage until that is paid off.  If you have the time, managing your personal balance between having several properties paid off and several mortgaged properties is ideal.  It might not be the absolute best allocation of money but it is one that can still give solid returns.

Leverage can be your most valuable tool as a real estate investor.  But finding your personal comfort zone and balance is key.

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