The Power of Leverage

Posted By: Chris Tanner ICOR Blog & News ,

Leverage in real estate is using borrowed money to buy a property. When leveraging a property, you borrow funds from a lender to be able to purchase an investment property instead of having to cover the entire purchase price yourself. The concept of leverage is pretty straightforward, but a more detailed explanation helps one understand the power of leverage.

Most people who invest in real estate need to borrow money as a way to buy a specific property. Typically, they do not have the entire purchase price available. But what if you could buy real estate with all cash? Is this the best method for obtaining real estate? Buying all cash has some advantages. It would certainly be a conservative approach as one would never be faced with a mortgage payment. This would eliminate the stress of having to make a monthly payment. Another advantage is the investor stands a better chance of keeping a property in the event of vacancy or any type of cash flow disruption. Peace of mind is valuable for some people and owning a property outright might bring that to an investor.

Let’s take a look at some reasons to consider using leverage. Using leverage may allow an investor to purchase more than one property. Owning multiple properties offers some advantages and disadvantages, but certainly one advantage is the idea of diversity. An investor can “diversify” by investing in different markets, or perhaps different types of properties. Single-family, commercial, multi-unit, etc... Owning multiple properties as opposed to just one means the likelihood of having every property vacant at the same time goes down. If you own a single property and it is vacant, you are receiving zero income, whereas owning multiple properties means you would likely have rental income while dealing with tenant turnover. The possible downside to owning multiple properties is dealing with more tenants.

The most powerful reason for using leverage is the return on investment during appreciating times. Let’s look at an example. Investor 1 has $300,000 to purchase an investment property using NO leverage. Let’s assume the investor holds that property for 5 years and it appreciates by 20%. When the investor sells the property, it is now worth $360,000. That is a 20% gain in value ($60,000 profit/$300,000 original investment). Not Bad! Investor 2 decides to use leverage and buys 3 properties. Each property requires a down payment of $100,000 and each property’s purchase price is $300,000. Investor 2 now owns 3 properties valued at $900,000 collectively. Using the same assumption of 20% appreciation after 5 years, investor 2 decides to sell all 3 properties. Each property sells for $360,000, so investor 2 nets $180,000 in profit. That is a 60% gain ($1800,000 profit/$300,000 original investment) for investor 2. By using leverage, investor 2 has triple the gain as compared to investor 1. Leverage is a powerful tool, especially in appreciating markets, but be aware that leverage can work in exactly the opposite manner in depreciating markets. In depreciating markets, the potential losses can be magnified if an investor is forced to sell at a price that is below their acquisition cost.

What about using leverage in a retirement plan? Most traditional retirement plans do not allow the use of leverage. If a retirement plan investor buys $100,000 in stock, they own $100,000 of stock. On the other hand, a self-directed IRA has the ability to incorporate leverage when investing in real estate A self-directed investor could use that same $100,000 to buy real estate valued at $300,000. The use of leverage has risks, but when managed intelligently leverage has the potential to boost returns on investments. Feel free to contact New Direction Trust Company to learn more about leveraged real estate investments.