Real Leverage — Well Worth Repeating

This is a post written last fall. It’s worth repeating. Leverage gets so much publicity, especially in real estate investing. Folks doing 1031 exchanges and first time investors think about it. They make a mistake when they define leverage merely and solely as a low down payment — resulting in control of significant real estate value. There are other considerations.

What effect do neg-am loans have on this definition of leverage? Ah-ha! Gotcha with that one, didn’t I? Bottom line — your investment will have to appreciate at a rate 2.75-4% higher than without a neg-am.

You buy an income property for $300K using a 10% down payment. The interest rate on your loan (cost of money) is 6.5%. You own it three years, but it only increases in value to $325K. You decide to sell. After all sales costs you net a few grand over what it cost to close the original purchase. Your annualized return on investment, to use a hackneyed phrase, was easily less than 6.5%. You say that’s obvious, and it is. However what most investors fail to see is, though you used leverage, it just wasn’t the big stick (lever) you ordered. Your stick never ‘moved the rock’. What? Here’s what I mean.

Leverage isn’t merely using a small or no down payment to control an investment property. It’s the calculated use of borrowed money. Whether you use a very small down payment or 50% down isn’t relevant to this definition. You see, there is positive and negative leverage. Sisyphus didn’t have what you’d call positive leverage, other than staying physically low himself. He had brute strength only. At best he had just above zero leverage and a ‘break-even’ at the top of the hill.

Do we all invest in order to break even years later when we sell? (Silly rhetorical question asked often by real estate investment brokers.) I’d almost want to keep pushing a big rock up a hill than continually break even on all my investments when I sell them.

• If your investment’s return is greater than your cost of money (loans) you have Positive Leverage.
• If however, your return, like the above example, is less than the cost of your money you have Negative Leverage.
• The cost of borrowed money vs the return on your invested capital is the paramount issue.

And that’s real leverage. Just remember to carry a really big stick — or get out of the way.

This is a principle with which all investors should be familiar. Although low down payments are surely one form of leverage, even the most popularly accepted, it’s not, or shouldn’t be its primary working definition. Just because you’ve found a stick (lever) to move that big rock, if that stick isn’t long enough or strong enough, you ain’t movin’ that rock. However, what if you move the rock with your stick? In real estate investment terms – you’ve made money.

Related posts:

1. Real Estate Investment: Real Leverage is Using a Big Enough Stick
2. Real Estate Investors: Keeping Your Eye On The Ball