How Financial Leverage Can Impact a Real Estate Investor's Returns
Financial leverage is a term associated with financing that refers to the use of borrowed funds to acquire investment property in order to use other people's money to make money.
Here's how it works.
When compared to the value of the property, the amount of leverage increases as the amount of borrowed funds increases, and decreases when the amount of borrowed funds decreases. Why? "Because the more of the bank's money used to make the investment the higher the investor's financial leverage."
For example, a real estate investor who borrows $800,000 to acquire a rental property valued at $1,000,000 would be getting a higher financial leverage than (say) an investor who borrows a lesser amount of $700,000 to purchase a rental property also valued at $1,000,000.
$1,000,000 property value
(800,000 ÷ 1,000,000) =
Financial leverage: 80%
$1,000,000 property value
(700,000 ÷ 1,000,000) =
Financial leverage: 70%
As a result, first investor is controlling a $1,000,000 asset with just $200,000 of his or her own money (1,000,000 - 800,00), compared to the second investor who put up $300,000 (1,000,000 - 700,000) to control the same value asset.
It should also be pointed out that had either real estate investor paid all cash and thus, borrowed nothing, he or she would not be using leverage because they would be using all of their own money to control the asset.
Fair enough. Now let's consider how the purchasing decision an investor makes to use financial leverage might directly impact their rate of return.
Financial Leverage and Rate of Return
Let's say that each of the two properties in the example above are subsequently sold after appreciating 10% in value, and thus provides each investor with a $100,000 gain on their total investment (1,000,000 x .10). Look how the returns vary:
First investor (80% leverage):
$200,000 cash investment
(100,000 ÷ 200,000) =
Second investor (70% leverage):
$300,000 cash investment
(100,000 ÷ 300,000) =
All-cash scenario (zero leverage):
$1,000,000 cash investment
(100,000 ÷ 1,000,000) =
As you can see, though each investor enjoyed a positive return on investment, the highest return was made by the first investor who used more of the bank's money and less of their own to purchase the property; and conversely, less of a return was made by the investors who used less of the bank's money and more of their own for the purchase.
That's the advantage of using financial leverage. The ability of a real estate investor being able to make money using other peoples' money.
Okay, but we should also point out another advantage to leveraging: it greatly increases the real estate investor's ability to purchase a larger property than if he or she was forced to pay all cash for it.
For instance, other than the all cash buyer above, it's likely than neither the first or second investor above could have made that $1,000,000 purchase. But even if they could have, they would have collected less rate of return than they did with the leverage; not to mention less available cash on hand to make other investments.
Rule of Thumb
There are distinct advantages for real estate investors to use financial leverage, but 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') that could result in the investor losing 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.