The Power of Leverage? Or Not…

Often I visit a great real estate social network called Bigger Pockets.  Recently a new member at the site, Daniel, outlined his investment strategy that was focused on buying properties cash, re-investing all cash and salary and building a portfolio slowly and safely.   See the thread here.

I am not going to knock his strategy, but I wanted to sit down and run the actual numbers to see what the actual difference in return is.

For our hypothetical situations we will compare three scenarios:

  • No financing
  • Financing 50% of your total investment at 8% interest only
  • Financing 80% of your total investment at 8% interest only

Assumptions we are going to make in all scenarios:

  • The non-interest expenses ratio will be 40% (this will include ALL expenses taxes, insurance, vacancies, maintenance).  This is conservative in my opinion; a vigilant California landlord should be able to beat this for single family rentals.
  • The owner of the property will manage the tenant at no additional cost.

I decided to run three real rental properties I purchased in 2009.

The results are more or less what I expected.  Clearly the more financing you get the higher your ROI is but for the benefits of financing to pay off your ALL CASH yearly ROI needs to be less than your cost of funds.  So if you are borrowing money at 12% instead of 8% on Prop A and you finance it to 80% you will be breaking-even and it is really a lot worse than that because you have 20% of your money invested in the deal, earning $0 return and your managing a property for free.

Now for the fun part of the project, let’s make some wild assumptions and assume 10 years from the purchase the property will return to the previous 2006 peak value.  I have no idea if the market will ever get there again and as long as I am cash-flowing I don’t really care if it ever gets there.  But what does it hurt to run the numbers.

The assumptions I made for this are:

  • You sell the property at peak value
  • You incur 8% of the sales price in disposition costs (real estate fees, escrow, closing costs, etc)
  • The property gets back to the peak valuation 10 years from the purchase
  • Rent stays flat

Again, I am not saying I think this is what is going to happen.

Essentially this really shows where the power of leverage can really spice things up.

And for my last point, leverage can go both ways.  If rents drop significantly, major disasters or any number of events happen your losses will grow to a level that might be unbearable if you use too much leverage. I read the book on the founder of In-N-Out and he bought almost all of his restaurants cash and in the beginning he rarely used borrowed money to grow.

I don’t think anything is wrong with owning properties free and clear (in fact it is part of my long-term strategy), but when properties can be purchased at these prices leverage can really be a great tool for investors to take full advantage of the market.

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7 Responses to “ The Power of Leverage? Or Not… ”

  1. Great Point here Steve. It is interesting to see how significantly an 80% leveraged property can trun %20-25 ROI. If only the banks didn’t make it so hard. I just closed on my 5th property and to get another loan the bank requires me to get nothing short of a cavity search – ha ha!

  2. Josh says:

    I agree Arthur, I have 5 free & clear properties and I cant find a bank that will let me pull money out of them…but a few years ago I could get a loan for 10x what I’m asking for now with no problem. grrrr.

  3. Josh,

    That is crazy!! Congrats on having 5 free and clear though! Looking back would you pay them off so quickly?

    I have roughly 90K to invest and I am wondering if I should pay for 1 in cash/ finance one or leverage 3 properties.

    Best,

    AG

    AG

  4. Mike Z says:

    Another interesting angle on this idea is if you paid cash you could have only gotten 1 Property last year. If you had 50% leverage you could only get 2 properties and if you had a 80% loan you can get all 3 properties. If you add this wrinkle to the scenario the outcome will be even wider!!!

    In the end do the numbers and they won’t lie (Assuming you use real numbers and not some make believe numbers)

  5. Couldn’t agree more.

    I don’t use any of my own money in almost all of my deals (mostly fix and flips). Private investors fund all the purchase and repair costs, even the rentals and owner finance wrap properties because they are bought so far under market value.

    Sometimes people are afraid of leveraging because they don’t want to get over extended. This should not be such an issue if you always buy right. Right being far below market value.

    Great blog.

    Danny

  6. Bilgefisher says:

    Gotta agree with Danny. I also think the key is to have good reserves. Tied up equity earns 0 interest. Your only hope is the property appreciation stays ahead of inflation.

    Have good reserves and many of the worries go away.

    Good post Steve.

  7. Luis says:

    I debate with myself all of the time if the whole “own properties free and clear” is really a wise investment. Like Josh says, when you own properties free and clear all you have is a bunch of money trapped and possibly not working as hard as it could. It is possible that your return on a free and clear property might be better than what you get in the stock market but the fact that the money is not liquid just makes me feel uneasy.

    Wouldn’t it be better to have the money in the bank, let the tenants pay the mortgage and use the money for short term investments? And then if you run into an emergency where you need cash, or the tenants leave or something else, you got plenty of money in the bank to cover yourself…

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