The power of leverage in real estate investment

Albert Einstein said once of compound interest, "It is the greatest mathematical discovery of all time". Compound interest is defined as the interest that accrues based on the total balance of principle and accumulated interest. Essentially, it is making money on money that is increasing, not being withdrawn. An equally important discovery, as it relates to real estate, is the concept of leverage. By definition, leverage is the use of credit or borrowed funds to improve one's speculative capacity and to increase the rate of return from an investment. The key words here are "borrowed" and "speculative". Each of these words indicates some degree of risk... the risk of an obligation to repay, and the potential risk of suffering a financial loss.

As an example of leverage, let's assume a real estate investor purchased a property in the Boulder Valley for $250,000 in January 2000. The investor obtained a non-owner occupied loan for 7.5% interest at an 80% loan-to-value, i.e. $50,000 down payment. The investor leased the property. With the tax benefits for depreciation, interest and property tax deductions, and deductible operating and maintenance expenses, the investor is able to break-even on the property from a cash flow standpoint.

Over a period of approximately six years, the property appreciates at a conservative five (5) percent per year. Using simple math, that makes the property worth about thirty (30) percent more than the original purchase price, i.e. $325,000.

The investor decides to sell the property and, after closing costs etc., nets $300,000 minus the existing mortgage ($186,555)... $113,445 in equity. Now the question becomes, what is the investor's financial return on his investment? Did he make money on his money?

Again, using simple math, if the property broke-even from a cash flow perspective, the investor realized $13,445 in additional equity through debt reduction and $50,000 in pretax profit... a total of $63,445 in gain. Based on the original $50,000 investment (which the investor received back at the time of closing on the property), the overall gain was about 127% or over 21% per year.

The power of leverage in real estate is the ability to sensibly use debt for the purpose of obtaining a greater return on the funds being invested. The key word here is "sensibly". Investing in real estate is not a get-rich-quick scheme. It takes thoughtful planning and patience to maximize one's return on investment.

In the example above, if the investor had sold the property two years after purchasing it, his return on investment would have been closer to zero. Closing costs etc. required to resale the property would have exhausted any realized appreciation and debt reduction.

In real estate investment, there are two schools of negative thought. The first is the school of "If Only". People say, "If only I had invested in real estate five or ten or whatever years ago, I'd be rich today." Well, maybe not rich, but if they had "sensibly" invested, they might be better off today financially.

The second school of negative thought is the school of "Never Again". People say, "I missed my chance. I'll never have the opportunity to invest in real estate. Prices are too high or property is not going to appreciate." Maybe, maybe not. There is that "degree of risk", again, that we talked about earlier. Unless you are hiding your money under your mattress or putting it into a government/financial institution-secured investment, most investments have some "degree of risk".

The power of leverage in real estate is there for everyone to acquire. It essentially takes a commitment to a risk/reward investment strategy that fits within each individual's vision of how his or her life should be.

I am experienced in helping real estate investors find and purchase suitable investment properties at the best possible price and terms available, and have access to top notch professionals to help investors make well-informed decisons and get the most out of their real estate investment portfolio.

Contact me for all your real estate investment needs! 
   

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