Let’s talk about leverage
I received a call yesterday from Victor, an investor that was interested in buying an investment here in South West Florida. We talked about the quadplexes I am offering, (Website here for one of them). I brought up the topic of leverage. I told Victor that that the real estate properties he can buy with leverage are better than deals he has to put more cash into. (He mentioned that he was looking to place all cash).
I realize that most of us think we know what leverage is. What I would like to do, however, is get pretty basic and review for you what leverage can do for you in real estate. This kind of leverage is almost impossible to get in other investments.
In mechanics, a lever is a device that will enable you to move a big weight with a very small weight. Leverage in real estate enables you to control an expensive piece of property with a small amount of cash.
First, let examine a property you buy with no leverage. Let’s assume you buy a $100,000.0o single family home. For simplicity sake, let us also assume that there were no other costs in acquiring the property. Our third assumption is that the property increases 10% per year in value (appreciation). You buy the property on January 1 by investing $100,000.
On December 31 the condo is worth $110,000. Your investment has earned you 10%.
If we are able to rent that property for $1000 per month, and we assume expenses of $167/month, we have additional income of $10,000. Now our investment earned a total of $20,000. For example:
Annual appreciation $10,000
Gross income: 12 months x $1000= $12,000
Our net benefit $20,000
Without looking at any tax advantages we have earned $20,000 ($10,000 appreciation and $10,000 income) or a total or 20% on our $100,000 investment. Pretty good, right?
Now let’s see how leverage works. Instead of paying cash for the $100,000 property let’s put up $20,000 and borrow the rest.
Annual appreciation ( same as above) $10,000
Gross income: 12 months x $1000 $12,000
Expenses w/o interest -$2,000
Interest expense for $80,000, 7% loan
for 12 months is -$5,574
Our net benefit $14,426
In the leveraged example we earned $14,426 on our $20,000 investment. This is a return of 72%. Sure beats the 20%, doesn’t it? This is what leverage is all about. Now keep in mind we have not even considered that you are paying the mortgage down ($813 the first year) so you are building your equity, or the depreciation that you can write off ($2909 the first year).
If you are thinking of getting a rental property in Florida. Call me first. Let's talk