The takeaway: You can dramatically increase your real estate investment returns by using leverage, which will leave precious funds availble for other uses. However, using leverage on the wrong investment can destroy your returns and have dramatic consequences. Choose wisely, Boomer.
It was a crisp evening in Fall 2020 I was in my PJs, with a big bowl of popcorn by my side. The TV blared. The presidential candidates yelled at each other. I yelled at them. It was complete chaos.
At one point in the yell-fest, Donald Trump boomed:
“I’m not that heavily ‘leveraged!’”
Reports of the first son-in-law being “that heavily leveraged” have also been in the news.
There seems to be a national preoccupation with “leverage” these days.
What is leverage?
When you buy real estate by making a down payment and borrowing the rest from the bank—that’s leverage. Donald Trump and his son-in-law use leverage when they buy buildings. You use it when you buy a house. But for now, let’s leave your personal residence out of it. (That’s an entirely different topic for a different day.)
Instead, let’s talk about using leverage to:
- supercharge your rental investment returns,
- feather your retirement nest egg, and
- build your rental real estate empire.
Rental real estate: paying cash vs. using leverage
Real estate fortunes are made and lost with “leverage.” “Leverage” can send your investments to the moon, or straight to that burning place below. Here’s how.
Let’s say you’ve found the perfect residential rental. With great delight, you’ve already read my post on buying residential rental property. 😀 You know how to protect yourself against the risks. All that’s left is to close on the rental.
If you have the money, you could pay cash and buy the rental outright. But you could also use leverage. Which one makes the biggest profit?
To answer this question, we have to use some sixth grade arithmetic.
Yes, I know it’s been a long time and can be scary. But we can be brave together knowing this information will make us some money. After all, if I told you that you could double your money by simply reviewing some sixth grade arithmetic would you do it?
I believe you would, Boomer.
So, for my arithmetic-phobic readers, (I know who you are), don’t be thrown by these numbers. Read for content. Be brave.
Again, which makes the biggest profit? Paying cash or using leverage?
Pay cash for the rental: no leverage, minimum gains. Say you pay cash for a $100,000 rental house. The next year it’s worth $110,000. Ignoring transaction and rental costs, you’ve just made 10% on the value of the house, which you own outright.*
*(Hey! How’d I get 10%? I used the formula for percent change: [(new number – old number) / old number] x 100 = (($110,000 -$100,000) / $100,000 = 10%)) To be sure there are fancy pants finance formulas we can use. But we’re keeping it simple, and making the point, with a one-year time period.)
Not bad. (Yawn.) Nothing to sneeze at in today’s environment. But let’s compare your return when you use leverage—i.e., when you finance the rental.
What if you’d used leverage?
Finance the rental: maximum leverage, maximum gains. Instead of paying cash, you put $10,000 down. You finance the remaining $90,000. As before, the home’s value increases to $110,000 the next year.
You now have the $10,000 you put down plus another $10,000 in appreciation. In effect, you now have $20,000 in equity.
Do you see what just happened there, Boomer??!!
You’ve just made 100% on your money!*
*[($20,000 – $10,000) / $10,000] x 100 = 100%)
Not bad at all, shrewd Boomer!!
Leverage gives you options.
Add a couple of zeros to these numbers and this is how real estate fortunes are made. At this point, you could:
- keep the house;
- sell the house and pocket your 100% investment return; or
- take the profit you just earned to finance another rental property and build your empire.
And that, my good Boomer, is the wonderful upside of leverage.
And yet …
Leverage can also destroy your options.
Let’s look at what would have happened had you bought residential rental property in 2008. Sadly, you bought just in time for national real estate values to drop by 30%. How does leverage affect this loss? Let’s have a look.
Minimize leverage (and loss) by paying cash. You bought a $100,000 rental and in one year the value dropped to $70,000. That’s a 30% loss.*
*[($70,000 – $100,000) / $100,000] x 100 = – 30%.
A 30% loss? Count.your.blessings.
What if you’d used leverage?
Maximize leverage (and loss) by financing. You bought a $100,000 rental and in one year the value dropped to $70,000. The house has lost $30,000 in value. Your $10,000 down payment is gone. You’ve also lost another $20,000 on top of that in terms of the home’s value. The percentage change between the minus $20,000 you’re in the hole and the $10,000 you originally put down is a negative 300%.
*[(-$20,000-$10,000)/$10,000] x 100 = (-$30,000/$10,000) x 100 = –300%.
Yes, gentle Boomer. You just supercharged your investment loss to the tune of 300%.*
By way of comparison, the S&P 500 lost 37% during the 2008 Great Recession.)
Add a couple of zeros to these examples, and that’s how real estate fortunes are lost. Now throw in some awful tenants and unexpected repairs. Voila! You’re getting friendly with the local bankruptcy attorney.
Leverage giveth and leverage taketh away.
There’s big money to make and lose in residential real estate—particularly if you use leverage. You can try your hand at it, Boomer. A lot of people do.
But on the off-chance that you would like to simplify your real estate investments, I’ll provide one more method of real estate investing in my next post.
In the meantime, remember that leverage is debt. Debt, particularly real estate debt, is the stuff of great fortunes—and multiple bankruptcies. Some can recover and become president. Most can’t.