Is Leverage Good?
My name is David Nielson and I have a love for numbers and creative financing. I love driving things that are fast, I work hard so I can play hard with my wife and my 4 amazing kids, and of course, I am The Best Flippin Lender™!
Recently, I taught my 7-year-old son about leverage by using a 2x4 and some blocks to move a large shed. I placed the 2x4 under the shed, put the block at the halfway point, and stood on the opposite end from the shed but the shed did not budge. I then moved the block closer to the shed, to create more leverage, and once again stood at the opposite end, this time only to see minor movement. Finally, I moved the block even closer, creating additional leverage, and was eventually able to move the shed.
Leverage is one way of utilizing a limited input to exert a maximized output. In real estate, the limited input that we utilize is our own capital, the leverage is OPM “Other People’s Money”, and once combined, that is our buying power. For example, lets show an investment of $25,000 in a house that produces a 12% profit, with leverage and without leverage. For this example, the leverage has a cost of 6%.
$25,000 Own Capital
+$75,000 Leverage or OPM
$100,000 Buying Power
$100,000 x 12% = $12,000 Gross Profit
$75,000 x 6% = $4,500 Cost of Leverage
$7,500 Net Profit with Leverage
$25,000 x 12% = $3,000 Net Profit without Leverage
Is leverage good? If all things go as planned, then the answer is yes. In this example the investor made an additional $4,500 which is 150% greater than without leverage. But what happens if a virus spreads across the nation and halts construction and your leverage has a 6-month maximum term, or the virus comes and causes your tenant to stop paying their rent when you rely on that rent to pay your obligations? At that point, the leverage may become your weakness.
Utilizing the example with my son, if the forces on each side of the 2x4 are too great, then at some point the 2x4 will break and you will have lost your leverage opportunity. In that instance, your hope is to either find a new source of leverage or find a way to amend/repair the current leverage. However, interest, late fees, default interest, and attorney fees begin working against you. Eventually you lose the property to foreclosure and your capital is gone. But wait, that is not all, not only did the lender take back the property and you lost your equity, but the lender then sold the property at a discount through auction and accumulated additional expenses. He then pursues the personal guarantee that you signed in efforts to make up for his additional loss.
So how much leverage is the right leverage? Well that is up to you and your risk tolerance. On Investment real estate, hard money lenders are riskier than banks and they lend between 80-100% of cost, banks lend below 80% of cost but are usually around 70%, and non-recourse lenders are closer to 50% loan to cost.
Equity in the property and cash reserves are key.