Financial Leverage as a Real Estate Advantage
In real estate investment, financial leverage is not only common but usually necessary, especially when you’re new to
investing in income property. Financial leverage is necessary first because of large capital costs, but equally and more importantly because of the need to increase the return on the investment. Let us explain.
Let’s look at an example of a duplex you’re interested in. Assuming you have carefully and accurately figured out your income, expenses, appreciation, how you’re going to manage it, and have negotiated the best possible price, now you have to do something: You have to buy it!
Is it wise to pay cash even if you have it and get X return that includes after-tax cash flow and appreciation? Or should you finance the property, given that it still has a very positive debt service ratio and cash flow (which means your net operating income more than covers your debt service)? The answer is usually easy. Assuming you have a normal loan-to-value ratio for the property, say 80% loan and 20% equity, you could buy four more properties with the cash you have, making your return five times what it is on the single property. This is a hard tool not to use. Done right you’ve increased your return by five times, and it could also mean you can buy the property with much less cash and get into it much sooner, perhaps one-fifth of the time a cash purchase would take. You’re using financial leverage and you may have increased the return on your investment. It makes the decision easy, but be cautious when it makes it too easy. You have to remember to be careful because leverage is a sword that cuts both ways. While it can magnify your return, it can also magnify your losses. Every mistake you make is magnified by leverage if you’re wrong about any of the projections you made regarding income, expenses and appreciation. Leverage also has a time component. Long-term assets need to be financed with long-term debt. There are countless examples of “good” real estate deals with incorrect financing, where the property was lost because balloon payments couldn’t be met. The problems with bad timing are just as bad as the problems of too much leverage. Once you buy the property, those projections are yours to live with. Those aren’t just numbers on paper anymore. They are expectations, and promises you made. You’re the manager now, and making those numbers happen is your responsibility.
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In the business of real estate investment, decisions must be based on evidence. This means evidence needs to be collected and analyzed in order to make a responsible decision, a process called due diligence. The more accurate and complete the evidence, the better the analysis. The better the analysis, the better the outcome of the investment can be.
Consumer decisions and purchases tend to be less analytical. They present more risk and immeasurable (less quantifiable) returns. This doesn’t mean consumer purchases are bad. It means there is usually little or at best unreliable return as an investment. Because of this unreliability, debt used in a consumer purchase or with a consumer mindset becomes a much greater risk with a number of negative consequences. We have all seen the terrible consequence to our economy and the world’s economy of too much debt. We’ve also seen the problems caused by the consumer mindset that falsely predicted home prices only go up and things only improve for investors and homeowners.
As witnessed in the disastrous economic results of 2007, there is a difference between evidence and deception, analysis and fabrication, due diligence and deliberate fraud. Even for business, debt used inappropriately isn’t leverage. At best it’s still just bad debt, too much fuzzy thinking. Remember: Leverage is a tool; debt is a condition. The reversal of Glass-Steagall in 1999 set off a tiering of many layers of debt in the banking industry with little to no regulation or transparency. What was euphemistically passing as “business decisions” from 1999 to 2007 (when our financial meltdown was finally exposed), in reality didn’t ever meet the standards of being evidence-based or reasonable. What passed for blame was the notion that investors and home buyers had become complacent and that regulators became overwhelmed. It’s fairly apparent now that there was no accountability and it was the regulators who were complacent. The investors and homeowners were misled by abusive and deceptive lending practices, such as the “no documentation” loans. For those involved in this deception, to blame this entire problem on overleveraged investments in toxic assets is an insult to bad investments everywhere. The fact is it wasn’t the assets that were toxic. The management and oversight of the leverage were toxic.
