Keepin’ Up With Everything Frank Doesn’t Know – Leverage

Wanted to give ya some food for thought going into the weekend. Leverage has been center stage in real estate and Wall Street the last few years. It’s meaning as it relates to investing of any kind was run through the meat grinder decades ago. In real estate investing, it now has the universal implication of the size of your down payment — a bastardized definition at best — a recipe for disaster at worst. The smaller the down, the more leverage applied. At best that ‘undersatnding’ is secondary to its primary essence.

The reason I bring this up is due to the flippancy with which the subject is tossed around in the media, at conferences I attend, and even by well intentioned real estate investors themselves. Viewing leverage as merely the ratio of down payment over debt is about as wrong as one might construe the concept. I’m reminded of a conversation on one of my all time favorite shows, M*A*S*H.

Seems Colonel Potter needed Hawkeye and BJ to be nicer to Frank. (Major Burns) Said Potter, “He’s not really a bad egg. There’s just some things he doesn’t know.” Whereupon Hawkeye responded sardonically, “But Colonel, it’s so hard to keep up with everything Frank doesn’t know.” One of the show’s best lines ever.

How then is leverage defined?

First we must understand there is positive and negative leverage, and it has zip, zilch, nada to do with the ratio of down payment/debt of an investment.

Positive leverage occurs when the return on the investment expressed as a percentage is greater than the cost (interest rate) of the borrowed money used to acquire it. Period.

Negative leverage then, is the opposite — the cost of debt (interest rate) is greater than the return (%) on the investment.

Here’s an example

You have a fourplex, and you buy it using 50% down, a very ‘low leverage’ position given the commonly accepted definition. The interest rate on your loan is 6%. You own the property for a couple years and do an historical analysis of your up to date return. It comes out as 14%. That’s classic positive leverage. Yet, the typical investor will conclude the leverage utilized was relatively weak based upon down payment size.

Same fourplex — this time with a 20% down payment — and the same 6% loan. The two year historical analysis clearly indicates a 5% return so far. Oops — classic negative leverage. That investment ain’t goin’ as planned. If something doesn’t change to move that return up to at least 6%, the ending won’t be what was most surely hoped for.

The most common false premise

Returns can fluctuate on one property showing positive leverage with a lower down payment, while a comparable property will show negative leverage with the same amount down. Assuming a low/high down payment ensures positive leverage can be deadly.

It’s all about Investment Physics. Leverage is unwavering in it’s consequences, as is gravity. We can use gravity resulting in both positive and negative outcomes.

Leverage is commonly defined as the ability to move something large and cumbersome like a large rock with a long stick. Look at negative leverage as you being on the wrong side of that rock when it begins to move. If you think you’re standing on the wrong side of your rock, um investment, there’s a chance you can ‘get on the right side’ to safety. If not, there are also ways we can often use to remedy the situation.

I’d love to talk with you about your portfolio. How’s it doing these days? You can reach me at 619 889-7100. Have a good one.

Related posts:

1. Real Estate Investment: Real Leverage is Using a Big Enough Stick
2. Real Leverage — Well Worth Repeating
3. Investment Physics Law — Leverage — Most Misunderstood
4. Question: How Does The Cost Of Leverage Factor Into An Investment?
5. Ideas — Principles — Concepts Matter Only When Words Mean Things