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Posted over 10 years ago

If CA$H is KING, then LEVERAGE is GOD - loans, cash, ROE / ROI & Risk

“If cash is king, then leverage is god.”

This is the witty response I heard from my former colleague, CFA charter holder, and current Capital Markets Specialist at a Federal Reserve Bank outside of CA, in a discussion about capital ratios, real estate leverage, and cash deals. Whether talking about real estate, a business, margined stocks, and especially banking, leverage can have a very large impact on Return on Equity (ROE) – also referred to as Return on Investment (ROI). Leverage magnifies returns, bringing larger gains when times are good, and sometimes striking fatal blows when fortune reverses.. Below are thoughts on the benefits and risks of leverage, points to assess when employing leverage, risk mitigants, and questions to be answered..

A recent study of Warren Buffet’s exceptional returns note that his use of leverage (both operational and financial leverage) on high-quality assets allowed him to earn a healthy ROE while avoiding many of the risks that might come with owning lower-quality assets without any leverage. The average community bank right now aims for capital levels around or a bit above 10% equity to total assets. That allows their ROE to be 10 times their return on assets. So earning 1% net income on all your assets earns a decent return on equity. If it’s 2% of assets, that’s a 20% ROE. But it can also fall dramatically. Much like a god, he may bless you, or may strike you down at a moment’s notice. ( in the figurative sense - not referring to any specific religion and no offense intended to any!)

Your average real estate deal with a 25% downpayment, various closing costs, some rehab money and liquidity, might leave you with around 1/3 or 33% all-in, or 3 times leverage. If and when real estate prices move up in your area, every 1% increase in prices leads to an additional 3% ROE. If prices follow the long-term target rate of inflation of the FOMC of about 2%, that would produce a 6% ROE on top of whatever value you create, cash returns you are earning, or principal you are paying down. But it also adds risk if rents decrease, if you don’t hold enough liquidity, or if loans are coming due or increasing and you can’t afford the resets/maturities.

FHA allows 3.5% down, and can receive seller’s credit for closing costs, leaving you potentially 30 times leverage. Which is phenomenal by any investment standard.. Every 1% increase in price produces a 30% ROE! Of course, these highly leveraged deals have a high debt load and mortgage insurance. So your cash flow cushion and liquidity cushion should be higher as leverage increases.. But the 30yr fixed rate and maturity provide more stability relative to variable rate loans and renewals every 5-10 years.

The risk of leverage also changes over the economic cycle.. Having heavy debt loads going into economic downturns can produce disastrous results, while leverage with increasing prices magnifies gains dramatically. As an investor with fairly high leverage right now, I take several factors into consideration to assess the risk of this leverage, and get a level of comfort with what the risk mitigants I have in place:

- How much excess cash flow do I have to cover vacancies, potential decreases in rents, to catch up re-filling reserves, etc..

- How secure are my cash flows? How much comes from a salary job and how stable is that job/salary? How high-quality are my tenants? And my rents relative to market?

- How much liquidity do I have? And how fast can I replenish it?

- How much access to credit do I have? How fast can I get it if I need it? Can it be cut off at the lender’s choice? Will the rate change? How fast do I have to pay it back?

- What do I have coming due? Balloon payments on loans? Interest rate resets in the next year or two? Am I relying on price appreciation to be able to finance or refinance future debt or principally payments?

- Can I sleep well at night with the debt that I have?

- When should I reduce my leverage and/or sell? How should the price of real estate, yield/ROE of assets, or the economic cycle play into that decision?

The answers for me are enough, fairly secure, enough/quickly, a lot/quickly/reasonable, nothing soon/no, I sleep well at night :) , and the last question, I am still trying to figure out.. For now, the cash flows are providing healthy returns after maintenance and reserves, I have sufficient cash and liquidity cushions, access to credit quickly at reasonable rates, I don’t need appreciation to refinance/pay my debts, and most financing is locked in at 30yr fixed rates, with some mortgage insurance to drop off later..

I’d like to think that if yields on real estate before appreciation drop to the phenomenally low yields they were leading up to the financial crisis (rock bottom cap rates), lenders are going wild, and everyone and their mom are getting 120% LTV loans on flips, I would either deleverage, sell, or make plans to protect myself from being overleveraged into a high-risk situation.. But it’s hard to decide when to pull the trigger on disposing of an asset that is raking in returns for you hand over fist.

So while cash is king and can get you a great deal on your flip, leverage is god by providing the leveraged returns that can turn your triple into a grand slam (if things go well). So when do you deleverage and sell? Do you sleep well at night knowing you have bullet payments due and variable-rate loans that may dramatically change your cash flow over the economic cycle? Are you debt free and enjoying every minute of it? Am I crazy for “advocating” for the benefits of leverage? (while acknowledging the risks that exist..)

Any feedback, comments, or questions are appreciated.


Comments (4)

  1. Loved the article J.  Leverage is additionally powerful when you buy below ARV, protecting yourself on the down side, and have great cash flow, allowing you to weather any economic downturn.  I used to fear all debt.  Now I only avoid "bad" debt. 

    I also liked J's response.  How can you not love an investment type where someone else makes you wealthy?  What a great business philosphy!

    Good luck in the future!


  2. J  I liked this article.  The topic is one I grapple with on a daily basis.  My wife does not like debt of any kind, and all money should only be i a CD.  I try to buy with as little money down have a hard time not spending anything setting in the bank at the end of the month.  We disagree on my investing a lot, but where else can you find a business that gives you a house at 20% of its current value just by managing it for 15 years?  other people pay the mortgage payments.  If you can get 10 properties to manage you will own 10 in 15 years, if you find 25 to manage you will own 25 in 15 years.  How do get any other investment that good?


  3. Thank you for a well written and articulated article presenting the risk and reward of leverage. Cash is, no doubt, king during recessions/depressions while leverage is god as we come out of a recession/depression. No one can argue against the best investor of all time in terms on owning high-quality assets at a discount (aka margin of safety) because they are almost always guarantee a return of your capital. Over-leverage might force an individual to sell his high-quality assets during a market downturn to raise capital. So if one wants to preserve his wealth, leverage responsibly. With respect to FHA loan, it is a great tool for first time home buyers to get into the real estate game. However, the price to pay is relatively steep in terms of an upfront fee of 1.75% and MI of 1.15% of the loan value. Buying right might allow a buyer to get rid of the MI soon due to having adequate equity (78% LTV). Sometimes, it makes sense to cash-in to get rid of the MI if the buyer has no better place to put his cash to work. Great article. Thanks for sharing.


  4. I love my leverage. I do own half of a mobile free and clear, and I had another until I sold it to my son. My other homes are leveraged though and I love the returns. I do have enough J.O.B. income to cover mortgages for a couple of months without ulcers if I need to.