For about a year, Randy has been ‘lurking in the shadows’ (his words), reading these pages. This morning he asked an excellent question, which allowed me to address one of the most misused, misunderstood concepts in investing — leverage.
Here’s Randy’s question:
Now when deciding to invest now or at some point in the future the cost of that leverage has to be taken into the total purchase price.
I noticed that you had been advocating making purchases given the current benign interest rate environment. Is there some rule of thumb that will dictate current purchase (or total ownership prices) in a higher interest rate environment … so in higher interest rate environments, won’t prices come down to account for higher financing costs? Is it not this simple (it never is)?
Randy — Great question — and no, it’s never that simple.
Here’s a factoid for ya. When I entered the business as a know-it-all 18 year old in October of ’69, the median price for a home, if memory serves, was under $20,000. Attach that fact to this one: I didn’t see an interest rate below 7% until the 21st century. Yet we had double digit appreciation for multiple years in the 70′s, 80′s, and early 2000′s BEFORE rates ever hit the 6% level. That’s well over 30 years.
Yet from ’69-2002 prices went up by a rough factor of 10 — or more. From that empirical experience, I learned. Interest rates are important, but there’s a ‘range of tolerance’ with which the market will barrel along, more or less unaffected. In ’79 when rates jumped to 10%+, that tolerance disappeared like steam in the air. But when it was 8.5%, property not only sold, but rose in value at impressive velocity. Yet today, home buyers and investors alike would scream like stuck pigs if rates went over 7%.
You make a keen observation about leverage. The public’s working definition of that concept is potentially dangerous. Simply acquiring property using low down payments is not what leverage is all about. The problem with that, is the results aren’t predictable. They’ll be positive most of the time — until they’re not. The million dollar question though, is why?
Here’s why. Leverage isn’t primarily a low down payment. It’s the acquisition of an investment using borrowed money wherein the cost of the borrowed money is less than the return on the investment. If you borrow at 6% and the property returns 9%, you’ve experienced ‘positive’ leverage. If however, the same property returns 5% you now have ‘negative’ leverage.
Notice I didn’t mention the down payment. Whether the investor put 0% down or 50% down, the property must return at a higher % than the cost of the borrowed money.
Over the years I’ve seen folks using huge down payments, but who ultimately lose due to negative leverage. On the other side of that coin I’ve seen folks use 10% down and enjoy hugely positive leverage. Using down payments as the ultimate test for leverage is the fastest way to learn this lesson the hard way.
That said, there’s still no accounting for one of life’s greatest investment truths: Your crystal ball and mine are just as cracked as the next guy’s. There’s no predicting the future. This is, in essence, why it’s called ‘risk capital’.
Here’s another practical factor as it relates to leverage and the real estate investor. If solid analysis clearly indicates a property requires 40% down to achieve positive leverage, the investor would do well to search for potentially superior alternatives. If they found well located equivalent properties in another region for which the same analysis demonstrated 20% down would result in positive leverage, they would now be able to acquire twice the property. That’s a good thing. 
Any time you can achieve the same or superior results using the same or less capital to control more property — to the extent it remains prudent — choose more property. What do I mean by prudent? Even when appreciation rates exceeded 20-30% I refused as a matter of policy to be any part of no-down loans. It’s silly, and in my opinion shouldn’t be used in the same sentence with the concept of prudence.
Look, if Property A needs 40% down to produce your required return, and you can get that return in an equally desirable setting on Property B for 20% down — why wouldn’t you opt for twice the property for the same capital? It’s at the point you’ve been able to acquire two Property B’s that the issue of down payment amount becomes a critical factor.
Investors often speak of the assumptions used in the analysis of income property as fundamentally crucial — a fair statement. However, it’s my contention their understanding of the underlying concepts implied by that same analysis is far more important in the long run. Well done research and analysis done with an erroneous understanding of any one investment concept renders the analytical results virtually without value — or worse — tragically misleading.
Am I making sense?
Let’s make sense together. We can begin by you calling me at 619 889-7100 or send me a note by way of the Contact BawldGuy button up top. Have a good one.
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