Increase Your Real Estate Returns Using Leverage.

[renatusus]

Leverage is the number one reason you can get such great returns on real estate. Most people don`t understand leverage or understand the principals that make leverage such a fantastic tool in your real estate investing arsenal.

First let me define leverage in the way it applies to real estate. You use leverage when you buy a $200,000 property with a 20% down payment and borrow the rest of the money from the seller or the bank. If you paid cash for the property you would need to come up with 200,000 and change at closing to take over a piece of real estate. You would be using no leverage and you would be looking for a return on your capital that would be similar to what you would get in other investments. If you made $2400 in rent per month and after expenses put $1500 cash in your pocket each month you would make $18000. This $18,000 would be your yearly return on capital invested. It is a good return and it is possible to make a good living buying property for cash. You can calculate your cash on cash return by taking your $18,000 profit divided by your $200,000 investment.

The number is given as a percentage. You would end up with a return of about 9% for the year. This is a good return on capital but not nearly what you can get if you use leverage to make your purchase.

Let me give you the same example but with a 20% down payment. You would have to bring $40,000 to the closing for your down payment and you would be financing $160,000 from the seller or the bank. Rates are relatively low now but they tend to be higher on investment property but I will use 6% rate of interest on the $160,000 financed. We can calculate what it will cost you in interest the first year by taking 6 % of $160,000. The amount of interest on your loan will be $9600. You are paying $9600 the first year of your loan in interest to use leverage. If you fully amortized the loan you will pay $959.28 a month principal and interest. This also leaves you the 160,000 in cash that you would have been investing in one property available in your bank account for other purchases so you are keeping your options open to buy more real estate.

Let`s take a look further at my example and see if you can actually make more money by using leverage.

You will still receive the same 2400 payment for rents per month except now we need to add in the interest cost into the calculation. You will still be taking in the 18000 a year but you have to pay your mortgage or at least the cost of interest out of cash flow. You will pay principal and interest of $11,511.36 out of your gross rents and your free cash flow at the end of the year will be only $6489 in our example. It looks like a lot less but let`s pencil out what return you can actually get by using leverage and not paying all cash.

We take the $6489 net gain for the year and divide it by the amount of capital invested which is 40,000 this time. So what looks like smaller gain in income becomes a much greater return as a percentage of your capital because the new calculation comes out to over 16% return on your investment.

Leverage is the key to profiting from real estate. It is possible to double or triple your return on capital invested by financing a portion of the deal. The lower your down payment the greater your return on your money.

 

[stephdietz]

Thanks so much for this lengthy description!

It is definitely important to have in your JV Presentation!! What in your experience works the best for explaining this?! Short and sweet? Or longer so they can fully grasp it and get the whole picture?!

 

[Thomas Beyer]

[quote user=stephdietz]What in your experience works the best for explaining this?
picture: chart with 3 bars:



bar one: cash/equity is 25%, mortgage is 75%



bar 2 (5 years later): higher bar (say up 20% due to 4%/year value increase), lower mortgage, more equity



bar 3 (10 years later): even higher bar (say up another 20% due to 4%/year value increase), even lower mortgage, even more equity



Related link here: http://myreinspace.com/public_forums/Real_Estate_Discussion/62-26733-133015-What_is_better_cash-flow__or_higher_ROI_.html

 

[Darr]

[quote user=renatusus] Most people don`t understand leverage



This much is true. However, when credit dries-up people then understand leverage considerably more and usually with catastrophic consequences.


Leverage is a double edge sword. It makes the good times roll and the bad hands fold.


Given the state of both private and public debt, the current environment is not conducive to highly leveraged purchases. Governments have no alternatives but to inflate the money supply which will invariably result in a tsunami of inflation. Lenders will cease lending (or lend on usury rates and conditions) and most likely will force you at renewal to puke your assets into stronger hands.


More can be found here:

http://myreinspace.com/public_forums/Real_Estate_Discussion/public_forums/Real_Estate_Discussion/62-26733-133015-What_is_better_cash-flow__or_higher_ROI_.html#133015

 

[Rickson9]

[quote user=Darr]This much is true. However, when credit dries-up people then understand leverage considerably more and usually with catastrophic consequences.

Leverage is a double edge sword. It makes the good times roll and the bad hands fold.


I agree.


[quote user=Darr]Given the state of both private and public debt, the current environment is not conducive to highly leveraged purchases. Governments have no alternatives but to inflate the money supply which will invariably result in a tsunami of inflation.


This author disagrees:




There is zero correlation between the Fed printing and the money supply. If you don`t believe this, you owe it to yourself to study up on monetary policy until you do.




This is an issue that brings them out of the bunker like no other in
economics. But if you are an investor, trader or economist,
understanding`and I mean really understanding, not just
recycling things you overheard on a trading desk or recall from Econ
101`the mechanics of monetary policy should be at the top of your
checklist. With the US, Japan, the UK and maybe soon Europe all with
their pedals to the monetary metal, more hinges on understanding this
now than ever before.


Here`s Why the Titans of Finance and Economics Are Wrong

 

[Darr]

[quote user=Rickson9] This author disagrees:

There is zero correlation between the Fed printing and the money supply.






I think Mark Dow (This author disagrees guy) should go back to school.



There's a near perfect positive correlation between money supply and inflation even in the face of declining velocity.



Here's a chart straight from the FED itself (the last people who would want you to know this) right here:

http://www.zerohedge.com/contributed/2012-08-10/inflation-m2-and-velocity-money





This "author" guy also goes on to say the following BS: `The Federal Reserve only provides liquidity. The amount of liquidity it puts in the reserve system has no direct impact on the issuance of credit by banks or shadow banks. Only banks and shadow banks can create credit`.


If that`s true, why does the FED have a Credit Facility? :


http://www.newyorkfed.org/research/current_issues/ci15-4.html


Honestly, the people who write in Yahoo Finance are either on the take or full of it.



This is quite unfortunate because a lot of people will get hurt believing the status-quo is sustainable.

 

[Rickson9]

The following is problematic:



The bottom line is the Titans are
working from the wrong playbook. We`re all, to varying degrees, slaves
to our experiences. Their formative experiences, almost to a man, were
in the early 80s. This is when they built their knowledge and assembled
their financial playbooks. They learned words like Milton Freidman, money multiplier, Paul Volcker, Ronald Reagan, and the superneutrality of money. Above all, they internalized one dictum: real men have hard money.



This understanding implies that an increase in bank reserves deposited at the Fed (i.e. `printing`) eventually feeds credit growth
and thereby inflationary pressures; in other words, no base money
increase, no credit growth. Only one problem: reality disagrees.



From 1981 to 2006 total credit
assets held by US financial institutions grew by $32.3 trillion (744%).
How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.



I haven't read any explanation for this? Except the aforementioned author's explanation, which is:



Today, length of collateral chains and haircut rates`neither of which are determined by the Fed`define the upper bounds of the money supply, not base money and reserve requirements.



Which seems reasonable?

 

[Thomas Beyer]

Rates will be super low for two more years, then the Fed will start tapering off their buying, ever so slowly, in 1/4 % increments per year for 3-6 years until prime rate is around 2.5 to 3% by around 2020. Already the US deficit is declining as a % of GDP, far faster than any other industrialized country. April was the highest ever month of taxes collected by the US treasury.



So, I conclude, the easing is working and we will be back to normal in 4-6 years, but normal is not what was normal, i.e. vast cheap credit to everyone. Loans will be available, as they should be, to car buyers and home buyers and businesses but not nearly as high as a % of asset value as we have seen in the 1990's and 2000's. A re calibration back to a new normal, lower than what we were used to since the late 80's, lower salaries, higher unemployment, less growth



There will be no hyper inflation due to lack of baby boomers buying as well as more normal lending practices and higher bank cash reserves.



Sensible leverage made sense in the past, and will continue to make sense. The keyword being " sensible" which means less than excessive but more than none.

 

[Darr]

I`m not going to dwell on bank reserves, capital adequacy ratios and bank leverage and credit assets as they can widen and compress according to the banks risk tolerance. I just don`t see why they must move in unison.





More important however is Debt, Deficits and GDP`s as it relates to leverage:







The use of leverage works best when available equity capital is high and debt burden is low.





According to economic reverse engineer par excellence Charles Biderman from Trimtabs, the deficit reduction is clearly unsustainable and is a tale of three one-off items masking a slow-growth economy:

• $61bn of the $140bn tax gains came from higher withheld income from the 135 million US workers. Only a very small percentage is a result of increase in wages and salaries; the bulk of this year's pop is due to higher tax rates not higher income.
• The bulk of the tax gains this year are from capital gains (which grew 30%) for assets sold last year into the fiscal cliff debacle;
  The FNM/FRE kickbacks - are at best unsustainable and at worst, a drag in a higher rate environment

You may watch his May 15 video `Do Not Mistake Higher Income Tax Payments for Liftoff` among others here: http://charlesbiderman.com/








As for an economy that`s 70% consumer related, the un- sustainability is undeniable as Americans have no more high paying jobs, underwater home equity, a decreasing labor participation force, over extended credit, increasing social liabilities and I could go on.





Not only has debt not been restructured, it's been papered over, amplified, aggregated and socialized. The malinvestments and over extended credit fuelling the economy of the past decades have not been creatively destructed. This needs to occur prior to a true recovery to begin. It will either happen with a deflationary deleveraging period or a collapse in confidence of the reserve currency. Since G7 central banks work in unison, one currency confidence event would trigger the rest thus marking the upper bound of the money supply.





Notwithstanding the possibility that this un-sustainability could go on longer than anyone can predict, one thing is certain however: this debt driven super-cycle must end eventually. Until that happens, it is best to be prudent and not a good time to be leverage complacent.

 

[Rickson9]

[quote user=Darr]

I`m not going to dwell on bank reserves, capital adequacy ratios and bank leverage and credit assets as they can widen and compress according to the banks risk tolerance. I just don`t see why they must move in unison.


Reserves at the central bank and available credit in the system "move in unison" because that's how money is created in a fractional reserve banking system?



Money Supply: How Money Is Created



(Skip to 13th minute to speed up the process)



If there is no available credit, there would be no money. Money supply would plummet.



The author is suggesting that this is no longer the basis for creating money (collateral chains now dominate), therefore predictions of inflation based on pre-collateral chain (i.e. credit-based money supply) are not accurate.



Today, length of collateral chains and haircut rates`neither of which are determined by the Fed`define the upper bounds of the money supply, not base money and reserve requirements.



Every other article talks about base money/reserve requirements and inflation. That is, the 80s money supply story. The author is suggesting that this paradigm (which is used to make predictions about inflation) died awhile ago, that is why "reality disagrees" with the predictions of inflation.



So far, the author appears to be correct.

 

[Darr]

[quote user=Rickson9] If there is no available credit, there would be no money. Money supply would plummet.


I agree with this only as it relates to the Fractional Reserve Banking System.



Debt as money is not wealth.



Since August 15th 1971, consumption and spending is driven by debt not savings.

This is also the starting point of the Debt Super Cycle and the source of the problem.





BTW, (as an aside) I love that video, have watched it many times and would encourage everyone to view it as it helps to demonstrate the un-sustainability of Fiat Money as it relates to Fractional Reserve Banking.



One thing that should be clear is that debt should not be interpreted as capital which comes only from saving ( retained earnings).



Debt today detracts from savings and consumption tomorrow.



A credit extension limit will eventually be called by creditors either through interest rates or currency exodus and Japan, the UK or the US is approaching that Minsky Moment.





Going back to the topic:

The bottom line for me is that people who have assets at risk should ease off the leverage throttle.



What do you think?

 

[mortgageman]

You should always use leverage safely, regardless of the current prevailing economic conditions since your personal economy, (your employment income, vacancy rate, large repair bills) can sink your real estate business if you are stretched too thin.

I've suggested before that landlords might want to take 10 year terms and lock in cost certainty on the largest expense in a business.

Thomas, I know you disagree with the 10 year term idea. We'll have to agree to disagree.

 

[Darr]

[quote user=mortgageman]You should always use leverage safely, regardless of the current prevailing economic conditions
Agreed, you should always use leverage safely, but in that spirit however, you may want to gear up when everyone is capitulating and gear down when the crowd is complacent. Now is the later IMHO.



I walk the talk on the 10 year also. Although for a reason you will not likely hear elsewhere. I'm more concerned about renewal risks than costs. Ultimately, you have to go with what you believe in and comfortable with.

 

[Thomas Beyer]

Locking in for ten years comes with three negatives, that have to weighed against the only positive, namely rate stability for ten years.




A) far higher costs for the next few years (30% or so more, a huge premium)




B) lower, far lower flexibility if one wishes to sell




C) inability to refinance in 5 years