What is Leverage?
We are so glad that you’re here, learning all about leverage. Why is leverage important, especially in the real estate industry? We think the best place to start is: what is leverage? Simply put, it’s using other people’s money to purchase your real estate asset. This money can come from the bank, seller financing, private funding, or alternate ways of using other people’s money to buy real estate.
What if You DON’T Use Leverage?
Let’s start with an example. We’re going to take this example in two different ways. In the first scenario, we’re going to use all cash to purchase a property because, of course, we’re made of money… joking! Ok, back to the example, let’s say we found an awesome four-plex, and we’re going to take our $400,000 and purchase it in cash. Now, let’s look at the income that our property makes in a year from collecting rents from our four tenants, which totals $45,600. Not bad, right?! That breaks down to $3,800 a month.
Now, we need to consider our operating costs, which will chip away at that $45,600. We’ve got insurance, taxes, maintenance, utilities, lawn care, and any other property-related expenses to deduct. Also, we can’t forget about property management fees because we like to pay ourselves! Therefore, at the end of the day, we’re left with $12,000 in net operating income (NOI).
Let’s calculate our return on investment by taking our $12,000 NOI and dividing it by the cash we’ve invested—$400,000. That works out to a 3% return, which isn’t fabulous, right? It definitely doesn’t make us want to take my $400,000 and invest it in that asset.
Purchasing a Property WITH Leverage
Now, let’s use leverage. So, we’re looking at the same property with the same purchase price of $400,000, but this time, we’re going to put 25% down for a bank loan, which is a clean $100,000 investment (we love easy math).
We’ll have the same expenses, but now we’re going to add debt service (aka mortgage), so our NOI will be less than in the first example. If only the bank gave us free money! That would be great, wouldn’t it?! But for easy math, let’s say our debt service is $6,000. So, we’re left with $6,000 in NOI (as opposed to $12,000 like the first example) at the end of the year. Now, let’s take that $6,000 and divide it by the $100,000 we invested. That gives us a 6% return on our investment. Tada, our return doubled!
Using Leverage Boosts Your Return on Your Investment
Using leverage essentially doubled your return. Now, we’re not necessarily happy with a 6% return, but you can see how using leverage essentially doubled the return on your investment. And 6% is a lot better than 3%, right?
The 6 Key Benefits of Using Leverage
We’re going to dive a little deeper into some additional benefits of leverage.
1. The first key benefit of using leverage is a higher return on investment.
When you don’t use all cash and instead use someone else’s money, that’s one of the best things about purchasing real estate—you can use other people’s money. You can’t just go around in life asking to use other people’s money, but in real estate, it’s one of the biggest advantages.
2. Your tenants are paying your mortgage.
You collect rent from your tenants, and that money is used to pay down the mortgage. So, not only are you using someone else’s money to buy the property, but someone else is also paying it off for you. It’s a win-win! Sounds pretty wonderful, as long as you screen your tenants well!
3. You can buy more real estate because you have more cash available.
Maybe you want to keep more money in savings, or maybe you want to go on that vacation. If you don’t put all $400,000 into one property, you could use it to buy three properties instead of just one. So, instead of putting all your cash into the first investment, you still have $300,000 to buy other real estate or use however you see fit.
4. Diversification.
By purchasing three properties instead of one, you have a more diverse portfolio. For example, in our portfolio, we have a property where we lost a lot of tenants all at once, and it’s not performing at its optimal level. But because we have a portfolio of other strong, cash-flowing properties, they’re able to carry the underperforming one. We’re not dumping a ton of cash into it because our other properties are supporting it.
5. The fifth benefit is tax advantages.
There are two main tax benefits. One is that you get to write off the interest on your mortgage, which is an automatic deduction from your taxable income. The second is your depreciation schedule. When you use leverage, you can either buy more properties and have more depreciation, or you can buy a more expensive property. If we want to buy a million-dollar property, we probably don’t want to put a million dollars in cash into it, but we still get to depreciate the entire million on our tax schedule. That’s saved us a lot of money on our taxes every year.
6. Leverage acts as an inflation hedge.
Essentially, you lock in an interest rate for around five years—sometimes up to ten. There are variable loans, but let’s say you lock it in for five to ten years. That rate is guaranteed, which protects you against inflation.
We locked in some of our loans when interest rates were really low, and now, as rates have gone up, we’re seeing the value of locking in that lower rate. Of course, you need to strategize and time it right, depending on the market cycle, but that’s a whole other topic.
Quick Recap!
Okay, let’s recap.
- Number one: your return on investment is significantly higher with leverage.
- Number two: your tenants are paying down your mortgage—win-win!
- Number three: you have more cash to buy other properties or use at your disposal however you see fit.
- Number four: you get diversification. If one property hits a rough patch, your other properties balance it out.
- Number five: there are lots of tax benefits.
- And number six: you get an inflation hedge by locking in your interest rate. Those are the six key benefits of leverage!
Join Our Community on Facebook!
We’d also love to know what creative ways you’ve used leverage to purchase real estate. We’re always looking for new ideas! So, jump over to our free Facebook group here and join the conversation—we’d love to see you there.
