Real Estate Investing

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In real estate investing, leverage is simply using borrowed money to increase your return on investment.

It is the key to almost all real estate investments and is based on the assumption that the borrower can earn more in income from borrowed money than what he or she pays to actually borrow the money (interest).  This of course is a fairly easy and simple concept to understand - and a wonderful investment vehicle when it works.

For instance, lets say I borrow money from a bank at 7% interest.  I then turn around and lend that money out at 10% interest.  In essence I am making 3% interest on the money (less closing costs, etc.).  Borrowing and lending in this circumstance can be risky at best, and illegal at worst.

However, if I was to use that money to invest in a piece of property, and I was collecting rent that covered my principal and interest payments - then I’d be making money.  Or if I borrowed the money to buy a house, and then resold that same house for more money - if the difference in the two prices is more than the interest I paid - then I come out ahead.

Leverage also allows us to maximize our return on investment, by allowing us to invest less, but earn more.

I usually like to use real-life cases and examples, but for the sake of simplicity and to get my point across - I’m going to use nice simple round numbers (albeit unrealistic).

Let’s say you have $50,000 to invest in some real estate.  If you were use that $50K to buy one house valued at $100,000, your Loan-to-Value ratio would be 50% (50/100).  If the house went up in value over the course of a year by 5% to $105,000 and then you sold it, you would make $5000.  This would be a 10% return on investment (ROI).

The example above is actually a very good example of the use of leverage.  By borrowing money from a bank, you were able to use less of your own money.  So even though the property itself only went up 5%, your money actually grew by 10%.

Now, let’s say instead of buying one house with the $50,000 - you decide to buy two houses.  Most banks and lenders will allow a 75% to 80% LTV on investment property, so you could buy two $100,000 houses using $25,000 of your own money on each.  Now, if you held on to both houses over the course of a year and they went up by the same 5% and then you sold them - you would make $10,000 in profit ($5,000 each).  So you’ve now made $10,000 off the same initial sum of $50,000 - a 20% return on investment!!

Of course the two examples above don’t take into account a whole host of issues:  taxes, closing costs and sales commissions can eat into your money at both ends of the deal, you need to make sure your rental income is a positive cash flow (meaning it covers the mortgage payments) and if not you have to factor that into it, and of course you might have to put money into the deal to fix the house up, advertise for tenants, etc.

But the point is the same the less of your own money - and the more of Other People’s Money (OPM) - you can put into the deal, the bigger the return on your own money at the other end.

Always invest as little as possible and buy as much as possible within your own tolerances for risk and your own knowledge of the situation.