Leverage and how to use it to your advantage in Real Estate
Why is real estate such a great way to invest your capital? Leverage is the number one reason you can get such great returns on real estate. Most people don’t understand leverage or understand the principals that make leverage such a fantastic tool in your real estate investing arsenal.
First let me define leverage in the way it applies to real estate. You use leverage when you buy a 200,000 property with a 20% down payment and borrow the rest of the money from the seller or the bank. If you paid cash for the property you would need to come up with 200,000 and change at closing to take over a piece of real estate. You would be using no leverage and you would be looking for a return on your capital that would be similar to what you would get in other investments. If you made 2400 in rent per moth and after expenses put 1500 in your pocket cash each month you would make 18000. This 18000 would be your yearly return on capital invested. It is a good return and it is possible to make a good living buying property for cash. You can calculate your cash on cash return by taking your 18000 profit divided by your 200,000 investment.
The number would end up as a percentage. You would end up with a return of some where around 9% for the year. This is a good return on capital but not nearly what you can get if you use leverage to make your purchase.
Let me give you the same example but with only 20% down payment. You would have to bring 40000 to the closing for your down payment and you would be financing 160,000 from the seller or the bank. Rates are relatively low now but they tend to be higher on investment property so I will use 6% rate of interest on the 160,000 financed. We can calculate what it will cost you in interest the first year by taking 6 % of 160,000. The amount of interest on your loan will be 9600. You are paying 9600 the first year of your loan in interest to use leverage. This also leaves you the 160,000 in cash that you would have been investing in one property still in your account for other purchases so you are keeping your options open.
Lets take a look further at my example and see if you can actually make more money by using leverage.
You will still receive the same 2400 payment for rents per month except now we need to add in the interest cost into the calculation. You will still be taking in the 18000 a year but you have to pay your mortgage or at least the cost of interest out of cash flow. You will paying interest and you net gain at the end of the year will be only 8400 in our example. It looks like a lot less but less figure out what return we are getting on our money invested.
We take the 8400 net gain for the year and divide it by the amount of capital invested which is 40,000 this time. So what looks like smaller gain income becomes a much greater return on you capital because the new calculation comes out 21% return on your investment.
Leverage is the key to profiting from real estate. It is possible to double or triple your return on capital invested by financing a portion of the deal. The lower your down payment the greater return on you money. Using leverage to invest in income property is the smartest way to get the most of your capital.
The other thing to remember is that you could use the balance of your funds to purchase 4 more properties that would get similar returns so paying cash is not always the king when it comes to investing in real estate income property. It is possible to get even better returns on your money in real estate investing and I will discuss those in other posts.