Financial Leverage, A Simple Illustration
Financial leverage (also known as trading on equity) in the broadest sense refers to the use of debt to acquire assets. Therefore, with real estate investing we would refer to financial leverage more concisely as the borrowed funds a real estate investor uses to acquire an investment property.
Let's consider two examples to illustrate how the use of financial leverage (or simply leverage) could play out in a typical real estate investment scenario so you get the idea.
Mary borrows $600,000 to acquire an apartment complex valued at $1,000,000. Mary is using leverage because she is controlling a $1,000,000 asset with just $400,000 of her own money.
John borrows nothing and instead purchases an office complex for $600,000 all-cash. John is not using leverage.
Okay, now let's take it a step further and show you how the purchasing decision each investor made can directly impact their returns.
Let's say that each of the properties are subsequently sold after appreciating 10% in value. Mary would have a $100,000 gain on her $400,000 investment, or a 25% return. John, on the other hand, would have a gain of $60,000 on his $600,000 investment, or just a 10% return.
But that's not to say that a higher financial leverage is necessarily always better for the real estate investor than lower leverage because there are times when it can have the opposite effect.
Say, for instance, that the properties illustrated in our example 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%, and John would suffer a loss of $60,000 on his initial $600,000 cash investment, or just 10%.
That said, though, we must not lose sight of the fact that leveraging is the use of other people's money; and when it's used intelligently, it provides real estate investing an advantage offered by no other investment vehicle. As a rule of thumb, 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.
Another advantage here is that leveraging 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. With 60 percent leverage Mary controlled a much larger property than John did without any financing.
Of course, 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 causes the investor to lose money on each dollar borrowed.
So before you make a decision regarding any proposed mortgages (or none at all) for your investment real estate opportunity, carefully analyze the bottom line by crunching the numbers.
Because if you select what might prove to be a profitable property and apply the right amount of financial leverage, you could certainly enjoy the best of what real estate investing has to offer.
Here's to your success.