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Leverage
Real estate investing is kinda cool, I like to think. From building long term wealth to generating residual passive income, there are some really powerful benefits to investing in real estate. One of the things that make real estate so attractive is the ability to leverage debt. When most people hear the word “debt” they automatically think “bad”. We’re told to avoid debt where possible, pay debt off as fast as possible, and be debt-free. Used wisely debt can be a tool that maximizes your wealth and income. Used incorrectly, and it goes the other way.
Good debt and bad debt, as Robert Kiyosaki defines them, are as follows. Bad debt is debt that you have to pay yourself, typically on liabilities. In this context liabilities are anything that takes money out of your pocket every month (think car loans, credit card bills, etc.). Good debt, on the other hand, is debt that someone else pays back for you, typically on assets. Assets, opposite of liabilities, are things that put money in your pocket every month (think investment properties, dividend paying stocks, businesses, etc.).
Using debt to purchase income-producing real estate can be a great thing that magnifies your return on investment. Any time that you can achieve a higher ROI by using debt than you could without, is good leverage.
Let’s look at an example of how debt can impact your cash on cash return of a rental property.
Scenario 1: Cash Purchase
You buy a $50K rental property without using debt. This means you buy the property for all cash. The property rents for $500/month.
Your expenses for insurance, taxes, maintenance, and management total $200/month.
Your cash flow is $300/month or $3,600/year. $3,600 divided by your investment of $50,000 = 7.2% cash on cash return.
Scenario 2: Using Debt
You buy the same $50K rental property in Scenario 1, but this time you use debt. With a 20% down payment of $10,000, you borrow $40,000 at 4% for 30 years (a typical fixed-rate mortgage).
The property rents for $500/month.
Your expenses for insurance, taxes, maintenance, and management total $200/month.
Your mortgage is $191/month. Total expenses including mortgage = 391
Your cash flow is $109/month or $1,308/year. $1,308 divided by your down payment of $10,000 = 13.08% cash on cash return.
Even further – let’s look at appreciation. Let’s say the $50K property appreciated at 5%, to a value of $52,500. This is a gain in equity of $2,500.
Scenario 1: Cash Purchase
$2,500 in equity gain / $50,000 = 5%
Scenario 2: Using Debt
$2,500 in equity gain / $10,000 = 25%
Notice here that the amount of equity you have in your property does not matter. The property appreciated, regardless of your equity position. Both scenarios have the same appreciation rate of 5%. However, in scenario 2 using leverage, your return is 5x that without using leverage.
As my good friend Keith Weinhold from Get Rich Education says, the rate of return on equity is and always will be 0%.
Alright, so that’s the case for using debt to invest in cash-flowing real estate.
Velocity of Money
Let’s talk more about how to keep your money and, more importantly, other people’s money working for you. Knowing now that the rate of return on equity is and always will be 0%, we want to manage and minimize to a certain level the amount of equity we keep in an investment property. This can be done through several ways, once of which is doing a cash out refinance.
A cash out refinance is simply taking out a new loan on your investment property, paying off the original loan, and pocketing the difference. Let’s look at an example of this.
You buy a duplex for $55,000. With a long term fixed-rate loan, you put down 20%, or $11,000
Through a lot of sweat equity and hard work, you fix the place up, paint the interior and exterior, update the hardware and finishes, and do some kitchen and bathroom upgrades. You know have the property looking good, and fully occupied with each unit renting for $550 per month.
2 years later, you realize that the properties in your area are selling for much higher than you bought yours just 2 years ago. Most of this is due to you buying the property off-market and partly due to an appreciating market. Knowing that you likely have a significant amount of equity in the property (what it’s worth minus what you owe) and decide to explore a refinance to capture some of that equity to put to work in another property.
After talking with your lender and applying for a new loan, the appraisal for your property comes back at $110K, coincidentally 2x what you paid for it 2 years ago. This means you have significant equity in the property. Now some would think to pay down the property and be debt-free. But all that equity is trapped in the property then and not working for you. As the savvy real estate investor, you are, you want to capture that equity and roll it to another property.
So you are able to refinance your property leaving a healthy 30% equity position in the property, and borrowing 70% of the $110K. This means the bank will lend you $77K, which you use to pay off your existing loan of $43K (it started at $44k, but you’ve paid it down over 2 years). You take the $77K, pay off $43K, and are left with $34K to use at your discretion. You could go to Cabo, buy a new car, or roll that money into another investment property.
Doing this, you are maximizing the velocity of money while using the power of leverage. This is how you can snowball a real estate investment into real estate empire.
Categorizing Your Goals
Using debt, maximizing leverage, controlling more assets, and taking on more good debt are concepts that may seem counterintuitive at first. But so is being wealthy. To be wealthy, look at what other wealthy people do. If this sounds unusual to you, I encourage you to think more about it, talk with other people who have built real estate portfolios, and see for yourself how using debt to buy cash flowing real estate can help you build the life you want.
Resources
Mortgage Calculator from Bankrate
Get Rich Education
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