The power of leverage!

The power of leverage! – Time is money, use them both wisely.

This is part 3 of 4 on how I got started in real estate

Now that we are discussing mortgages we can talk about the concept that sets real estate apart from other investments: leverage.

Leverage is simply using other people’s money to make more money for you. In the stock market you pay 100% of your money to control 100% of your investments. In real estate you pay 20% of your money to control 100% of a property. When you sell that property or generate monthly income on that property you are making money against the full value of the investment -- your returns are multiplied. To understand how leverage works look at the example of three people who have $100,000 to invest in real estate.

Person A bought a $100,000 rental property outright. After taxes, insurance and property management fees, the property generated a cash flow of $500 a month. At the end of the year Person A will have made $6,000 – a 6% return on investment.

Person B invested $20,000 into five different rental properties. After mortgage payments, taxes, insurance and property management fees, the properties generated a cash flow of $200 a month per house. At the end of the year Person B will have made $12,000 – a 12% return on investment.

Not only is Person B making more money than Person A but she also controls $500,000 worth of real estate, compared to only $100,000, which means more opportunities for home value appreciation and lower risk since Person B is better diversified with five different renters. The more homes you own, the more diversified you become. Owning one unoccupied rental home when super storm Sandy floods your house means losing money. With five rental homes and one unoccupied, the four others will provide an income buffer for you until you can get the home rented out. Also you can diversify by picking different neighborhoods, different sized homes or different renter types.

Person C invested all $100,000 into the Vanguard REIT (VNQ), the stock market was flat for this example year but they still earned 3.30% in dividends. At the end of the year Person C made $3,300 – a 3.30% return on investment. Person C had the lowest risk of all since she was diversified into hundreds of real estate holdings inside the REIT but also had no control over what the REIT invested in, what rent to charge, and who they rented to. The advantage Person C has is liquidity of her investment. If she needs her money out now she simply sells her shares and in a few days the money is there. With real estate, selling a home is a much longer process which is why I would never tie up money in real estate investments that I might need in the next several years. Real estate makes up 40% of my net worth and the remaining 60% comes from workplace 401ks, IRAs and savings. I treat real estate almost like having a long term bond allocation – my goal is consistent monthly income and gradual home value appreciation.

Leverage is an awesome tool, but it can work against you. There could be times when real estate values decrease several years in a row and you could find that you owe more than the home is worth. You could find yourself “underwater” on your mortgage, especially if you invested with 0% or 5% down which was common prior to 2009. If rent prices stays stable you can ride out the storm and wait for the housing market to start improving while still covering all your expenses. But if the market really crashes, you could find that rents go down as well which can eliminate your profit margin and cause additional downward spirals of the housing market.

The key is to find your personal balance between leverage and your tolerance for debt. Personally I don’t think I will ever feel comfortable with more than five mortgages at one time just because I don’t want the stress of all that debt. I know there are lots of investors out there who have hundreds of homes in their portfolios and are all highly leveraged. I balance my risk by saving up to buy the next property while at the same time adding extra payments to my highest interest mortgage until that is paid off. This lets me find my personal balance between having several homes paid off with several mortgaged homes. It might not be the absolute best allocation of my money but it is one that gives me solid returns and lets me sleep well at night.

A real world example of how you can maximize leverage is how we purchased our third rental home. I purchased the house from an investor who was moving away from the area and did not want to manage his rentals from a distance. The house was a great four bedroom home in good condition and in my favorite neighborhood. A young family was already renting and wanted to stay in the home. I knew this was going to be a great opportunity - no renovations, no repairs, just instant cash flow! My issue was that I wasn’t planning on buying a rental home that year, I was saving up to buy one the following year and I didn’t have the cash on hand for the down payment and closing costs. But what I did have was two other rental properties that were paid off. I refinanced one of my properties for $40,000 – used that money for the 25% down payment and closing costs on the third home and then financed the remaining 75% to obtain the property. There are not many other investments where you can do that. You can’t buy $100,000 worth of Apple stock agreeing to pay Apple a few hundred dollars a month for the next 30 years at today’s price.

You’re almost done! You have found a home to invest in and have navigated the financing needed to acquire your rental property.In my final article I will discuss how to have long term success and form your real estate team.