To Leverage or Not to Leverage – This is the Question…
There is always a lot of discussion within the real estate circles on the subject of high leverage; specifically the issue of how high is too high. Let me come right out and tell you that I am biased in this matter – I specialize in creative finance and one of my objectives in each and every acquisition is to arrive as close to 100% financing as possible. Every technique and every negotiable term within my world of creative finance and acquisition exists for one of two reasons – either to make the deal more profitable, or two make it possible, or doable, in the first place. Leverage can do both! So, let's talk leverage…
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Do You Have Cash?
Real estate investing, as it relates to acquisition of long-term income-producing property, is a cash-intensive game. Do you have cash? If you needed to hand over a check representing 25% of the purchase price on a $160,000 building to an institutional lender, would you be able to it?
I can tell you that when I started I could not, and in this way I was likely no different from most people reading this article. The consequence of not having a lot of money is that we either have to utilize higher levels of leverage in order to enter the game, or we must simply accept defeat before we even start. Since defeat is not an option, we are left with leverage.
I don’t know how much more plainly I can put this for all of the naysayers who oppose leverage in all of its incarnations. If you inherited money or are fortunate to be in high-paid professions which facilitate making fat down-payments on your real estate acquisitions – good for you. But, for those of us who are less fortunate, creative utilization of higher levels leverage is an absolute requisite –period!
What about the Returns?
But aside for allowing us into the game, leverage also makes our deals much more profitable as it relates to Cash on Cash return. Let us consider a hypothetical purchase of a 4-plex for $160,000, where the Gross Income is $2,400/month (600×4) and the Operating Costs are $1,000/month, leaving us with the NOI of $1,400/month. Let us evaluate the Cash on Cash return in this deal based on three financing options: 25% down, 10% down, and 100% financing.
Recognizing that the exact terms of the underlying financing will play a HUGE role in this, a subject that will have to be covered in future articles, for the scope of this discussion let us assume that the financed portion in all of the examples will be represented with a 30-year amortized note at 6%. Also, let's assume that the closing costs in each of the examples are wrapped into the financing. And finally, let's say that all of the units are rented on the day of closing and that there are no immediate delayed maintenance issues. Below is a rudimentary analysis of the cash flows in each of our examples:
Purchase Price: $160,000
Cash Down-Payment: $40,000
Financed Portion: $120,000
Cost of Money: $720 (rounded off)
Cash Flow: $680/month (CF = NOI – Cost of Money)
*Cash on Cash: 21% (COC = Annual CF / (Down-Payment + Closing Costs + Repairs)
Purchase Price: $160,000
Cash Down-Payment: $16,000
Financed Portion: $144,000
Cost of Money: $864 (rounded off)
Cash Flow: $536/month
*Cash on Cash: 41%
Purchase Price: $160,000
Cash Down-Payment: N/A
Financed Portion: $160,000
Cost of Money: $960 (rounded off)
Cash Flow: $440/month
*Cash on Cash: Infinity
A quick consideration of the above will bring to light several interesting realities:
Cashflow In the above example, going from a $40,000 down-payment to a $16,000 down-payment resulted in a relatively modest loss of cash flow of about $144/month – we went from $680/month to $536/month.
Question: Presuming that the underlying financials are strong enough to support doing so, would you be willing to give up $144/month of cash flow in order to keep $24,000 of your money in your pocket?
If you simply do not have $40,000 but you do have $16,000, would you be willing to spend an extra $144/month on your cost of money if doing so enables you to buy this building whereas otherwise you could not? For me personally, the answers are always YES and YES – you make your own decisions…
Infinite Returns I indicated that 100% financing in our third example resulted in INFINITY Cash on Cash return.
Question: How else would you quantify earning $440/month of cash flow having invested $0 of your own capital?
Insufficient Funds Most people would agree that the greatest obstacle to acquisition of income-producing real estate is insufficient funds for down-payments.
Question: Would you agree that 100% financing effectively bypasses the need for down-payments and therefore, at least in theory, it can enable you to down an unlimited number of deals?
- Leverage with Cashflow Last but certainly not least, please note that even at 100% financing, the property in this example is still showing more than $100/month per door of cash flow! Granted – not just any old 4-plex out of your local MLS will be able to do this for you. Leveraged deals force us to be very picky about what we buy indeed. An OK deal is simply not going to yield enough to allow for healthy cash flow when fully leveraged. We are forced to do only above average deals!
Hopefully, this gives you a birds-eye view of the benefits of leverage and ways in which leverage has the potential to impact out business in a very positive way.
It’s not all this simple:
For all of my apparent “love affair” with leverage, I am the first to admit that you must be smart and very well educated before attempting to utilize higher levels of leverage. Do not over-leverage the equity under any circumstances, though this may be tempting from time to time. Property values can and do cycle down with regularity and you need to be careful to ensure that all of the lenders are adequately collateralized. Leave yourself a margin for error. And most importantly, you must make sure that your Net Operating Income easily covers all of the debt service and leaves you with plenty of cash flow! The latter will allow you to weather the storms that inevitably will come your way!
By definition, leverage is one of the great advantages of real estate as an investment vehicle, and utilized correctly leverage tees-up great possibilities for a sophisticated investor!
Photo: L. Bernhardt, Resident Loon