Exploring Leverage: All Things Begin Equal – Sorry, But They’re Anything But Equal
First, let’s talk leverage. Better yet, let’s talk about the real definition. Hint: It’s not about down payment, not even close. In my experience, the vast majority of investors would say that, all things being equal, (A punch line to a bad joke if ever there was one.) a 10% down payment is a far better use of leverage than a 50% down payment. Also in my experience I’ve seen those using that false so-called ‘axiom’ come face to face with an old real estate investment joke.
“Using your workin’ definition of leverage, how do ya make a small fortune in real estate?”
“That’s easy — Ya start out with a large fortune.” Badda boom!
Alright already, what is leverage?
Let’s begin with the understanding that you can create negative or positive leverage — even neutral at times.
Positive leverage occurs when the yield on the investment is higher than the cost of money. For example, if the loan interest rate is 5%, and the return on your investment is 8%, you have positive leverage. It could be with no down, or 80% down, or anywhere in between.
If the investment’s yield is less than your cost of money, you’ve entered the negative leverage zone. Again, down payment is irrelevant. Now I’ll instantly contradict myself. Sometimes increasing the down payment can turn negative or neutral leverage positive. That scenario cracks me up cuz it allows the opportunity for me to claim ‘better leverage by increasing the down payment’ which irritates most investors no end. (It’s always the little things, isn’t it?) 🙂
All things usually aren’t equal.
You’ve found a few properties, but can only buy one. The loans for all of ’em will cost you the same — 5% interest. The analysis on the first one shows the overall yield to be 7.5%. And that’s when you say it.
“All things being equal, I’ll take the most positive leverage available.”
Oh really? Are the neighborhoods equal? Are they roughly the same age? Are the amenities more or less equal? The floor plans? The tenant demand? The relative physical condition? The price/rent ratio? And on, and on, and on.
When truly objective analysis is employed, as likely as not you’ll discover several things that aren’t ‘equal’, not matter how you spin it. Don’t ‘fix’ your analysis to conclude what you think you ‘already know’. I can’t count the number of times analytical conclusions have rocked my world — on both sides of the spectrum. What I’ve rarely seen is that, indeed, all things were equal. It’s one of the things investors tend to hide, even from themselves — that it’s rare when properties share ‘all’ or even most factors in common.
If all things really are equal, take the most positive leverage. Duh.
If it’s prudent to lower the down payment a bit, with a resulting increase in yield, do it. Caveat: In these times and economic atmosphere, my OldSchool adherence to, you know, rational thought, says anything below 20% down is foolish. There are exceptions of course, but rare as hen’s teeth.
Take the best location with the most positive leverage with the lowest down payment.
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And yeah, Captain Obvious lives. But even he knows two things.
Leverage isn’t about down payment.
All things are rarely equal.
Now you know too.