How Financial Leverage Can Impact a Real Estate Investor's Returns
In the broadest sense, financial leverage (also known as trading on equity) refers to the use of debt to acquire assets. When applied to real estate investing, however, we would refer to financial leverage (or simply leverage) more concisely as the borrowed funds a real estate investor uses to acquire an investment property.
For example. If Mary borrows $600,000 to acquire an apartment complex valued at $1,000,000, she is using leverage because she is controlling a $1,000,000 asset with just $400,000 of her own money. On the other hand, if John borrows nothing and instead purchases an office complex for $600,000 all-cash he is not using leverage because he is using all of his own money to control the asset.
In other words, financial leverage involves the use of other people's money to make money. And when it's used intelligently, it provides real estate investing an advantage offered by no other investment vehicle. In fact, when you can use someone else's money and make more money than it cost to borrow it (known as 'positive leverage'), it probably makes sense to do so because you can be making money on every dollar borrowed.
Okay, now let's take the example cited above to see how the purchasing decision each investor made can directly impact their rate of return.
Let's say that each of the two properties are subsequently sold after appreciating 10% in value. Mary would have a $100,000 gain on her $400,000 investment (1,000,000 x .10), or a 25% return (100,000 ÷ 400,000). Whereas John would have a gain of $60,000 on his $600,000 investment (600,000 x .10), or a 10% return (60,000 ÷ 600,000).
On the other hand, say that the properties should, in fact, decline 10% from their original value. Mary would suffer a loss of $100,000 on her initial $400,000 cash investment, or 25% (100,000 ÷ 400,000), and John would suffer a loss of $60,000 on his initial $600,000 cash investment, or just 10% (60,000 ÷ 600,000).
So financial leverage cuts both ways. But having said that, we should point out that another advantage to leveraging is that it greatly increases the investor's ability to purchase a larger property than if he or she paid all cash for it. We saw this in our example earlier. Mary, with 60 percent leverage, controlled a much larger property than John, who made his investment without any financing.
Rule of Thumb
Although there are distinct advantages for real estate investors to use financial leverage, without a careful examination of all the facts and figures it's also possible to take on a mortgage that costs more than the property returns (known as 'negative leverage') and in turn may cause the investor to lose money on each dollar borrowed.
So before you make a decision regarding any proposed mortgages for your investment real estate opportunity, be sure to carefully analyze the bottom line by crunching the numbers. This way you are more apt to apply the right amount of leverage, and in turn enjoy the best of what real estate investing has to offer.
Here's to your success.