If you’re buying your first or your fiftieth property, one challenge that almost every real estate investor runs into is financing their properties. In a perfect world, we’re all sitting on huge trunks of money and can simply purchase a property all cash. No financing required, no banks or brokers required and it all gets incredibly easy.
Yet, if it was easy, everyone would do it. And if everyone had trunks full of money, sites like mine wouldn’t be necessary as money is supposed to fix all problems.
So let’s get back to reality and talk about a couple of areas involving financing. These are the benefits of leverage that financing gives you and I’m going to introduce some of you to the concept of return on investment or ROI.
Leverage is one of the most exciting aspects of real estate and it’s also why so many people get involved as it allows you to get involved without completely paying for a property.
I’ll break out other exciting tidbits a bit further, but for now let’s dig into the power of leverage.
The Power of Leverage
If you’re just getting started with owning rental property, hopefully this little walk through can help you understand how leverage can benefit you as a real estate investor. To help get the point across, I have some examples that hopefully make it much clearer than just rambling on.
It’s also where you get to learn the basics of return on investment (which I’ll refer to as ROI going forward through this article). Anyone excited yet?
For ease of understanding, I’m keeping this to the very basics. I’m simplifying this by not taking into account any additional costs and expenses. These would typically include legal costs, taxes, financing setup costs, cash flow, mortgage pay down and many more annoying yet vital details.
Why skip these important aspects you might be thinking? Because I’m only making a point about leverage, (I’ll have a separate post about annoying yet vital details later to keep all the detail folks happy). So let’s go look at some examples!
An investor purchases a property for $100,000 all cash and over the next five years the value of the property has increased by 10% making it now worth $110,000. His $100,000 investment has grown by $10,000 and his ROI is 10%. That’s determined by dividing the growth amount or return, $10,000 in this case, by the original investment and multiplying by 100 to turn it into a percent. ROI is typically referred to as a percent so it’s easier to compare across properties, industries or sectors.
The formula being: (Growth/Original Investment) x 100.
In our example the numbers look like this: (10,000/100,000) x 100 = 10% return.
On a yearly basis, it works out to be 2% or the total percentage divided by the number of years. 10%/5 = 2% per year. With inflation normally between 2-3% per year, this is a break even situation at best, but likely a net loss.
In this example, let’s say you still have the $100,000, but decide to now put only 50% towards the purchase price ($50,000). Then you use traditional financing for the remaining 50%. Again, the value of the property has risen 10% over five years but the important difference is the return on the investor’s investment. Using the same formula, but with a much lower investment, we get some much better returns.
Here’s this example: (10,000/50,000) x 100 = 20%
Suddenly, that return has doubled. Even on a yearly basis (20%/5 years) it’s double at 4%, so now you’re potentially slightly ahead of inflation!
But the “aha” moment is you still have $50,000 and could repeat the process on a similar property. By duplicating this and purchasing two properties, your gross return would be $20,000 (2 x $10,000 in growth). Your individual (and your overall) return on both of these properties would still be 20%, so that doesn’t change, just the amount of money you at the end does which is the important factor.
This is where it gets exciting. We’re now going to look at only putting 20% or $20,000 down to purchase the original $100,000 property. With everything staying the same except the amount put down, 10% increase in value over five years, lets look at the return on investment calculation now: (10,000/20,000) x 100 = 50%
Anyone else excited? Same property, but now buying it with way less money and you’ve created a much larger return. Breaking it down to a yearly basis, you’re seeing a 10% per year return on your $20,000 investment.
Let’s rethink our “aha” moment and now consider buying five $100,000 properties with our original $100,000 by putting only $20,000 on each. With a $10,000 increase on each property, that $100,000 dollars that only increased to $10,000 in the first example now becomes $50,000. The same original amount; just leveraged to allow additional properties and resulting in a 50% return on investment. Which my friends, is the power of leverage!
And the Lesson Learned Is…
It’s also why you don’t want to typically buy a property all cash when financing is available. Is it always the case, no, but it is in my simple examples! The issues do get more complex as you add in mortgage pay-down, cash flow from having tenants in place and other external factors, but the one point I needed to convey with this article was the power of leverage. Hopefully, it made sense and it provided some clarity for you.
Bill Biko has become “the Educated Landlord” through both training and the school of life. With almost a decades experience of land lording Bill’s been mentoring and assisting landlords for the last five years and you can find more of his tips and articles to make your life as a landlord easier, more profitable and less stressful at www.TheEducatedLandlord.com.