Leverage: What a sexy word, don’t you agree?
Of course you do, seeing as every other thread I read this week on the Forums was leverage this, leverage that. And what does everyone want to know? The question was first asked by Bill Shakespeare: to be, or not to be?
Answer: yes, no, maybe.
It’s All About Cycles
The one thing that sets experienced investors apart from everyone else is that we’ve experienced cycles, both in the economy and in ourselves. The question of whether leverage is good or bad, and whether you should play that way or not, is a function of the cycle in which you operate.
Now, I am not breaking any new ground in saying that later in life you should use leverage very sparingly. You’ve heard this before, and you know this intuitively. Nonetheless, let’s spend a few moments on this…
A Great Benefit of Real Estate
I am infamous around here for saying that I do very few deals. In other words, I don’t feel like I have to do deals in order to feel accomplished. Indeed, I only want the deals that I want, and there is a very, very, very finite definition as to what I want in a real estate opportunity.
The logic goes like this:
The single greatest advantage of real estate is that it’s an inflation-protected security. Real estate appreciates as currency devaluates (monetary inflation), and it appreciates as the velocity of money increases due to organic economic drivers (economic growth). Naturally, there are cycles in real estate; we are, after all, based on a fractional reserve fiat banking system, lest we forget.
But over a long period of time, because real estate is very much a physical asset and because typically physical assets are denominated in units of currency, real estate grows in price as currency supply increases. (Or so it should, if you’ve bought the right thing – don’t get me started on that ’cause I could teach a course…)
What Does This Mean?
Well, I don’t want to get into the woods too much here ’cause I most definitely don’t get paid enough for that, but:
If you know that the currency will devaluate by 10% in the next 4 years, which will translate into price inflation of 10% in that same time, do you want to be in control of a $100,000 asset base, or $1,000,000, if your goal is to create wealth?
That’s right, the “largeness” of your footprint is crucially important in our economy. The same relatively low percentage change acting upon vastly different amounts of asset base will produce vastly different results. And while there are some in this audience who can handle a $100,000 cash purchase, there are likely very few who could come up with $1,000,000 in cash that wasn’t bridged via debt.
Leverage, my friends, is how we place ourselves in control of an outsized asset base. This is as simple as I can put it.
What About Risk and Age?
Simple — when you are older, you are no longer in the game of wealth creation. In fact, you should be in the game of wealth preservation, and leverage is not only proportionally more dangerous, but also unnecessary.
I am 40 years old, and to tell you the absolute truth, I cannot imagine starting from scratch at this age. It’s a damn good thing that my snowball is rolling, and all I have to do is just give it some momentum here and there.
One of my mentors told me when I was about 32:
By the time you’re 40, you need to have your stuff together; if you don’t, you most likely won’t…
Read that last line again…. ’cause he was right!
So yes, this is why I underwrite the way that I do; I do not lose money, and I don’t like to scramble like my good friend Brandon Turner. I’m 40, while he is a bearded baby… there’s not enough time to right the ship if I mess it up now, nor do I have the energy for all of the nonsense.
I am transitioning cycles in my life, and as much as I love leverage, and as much good as it has done, from here on out, the framework of requirements and limitations for the use of leverage looks quite different than it did 5 year ago.
Having said this, however, I repeat: I am a huge proponent of properly applied 100% financing, when it is appropriate!
Recognizing that devaluation of currency resulting in a certain amount of price inflation is a stated goal of our monetary policy, real estate is as well positioned as any asset class to protect and improve your buying power. If all you want is to retire with dignity, perhaps you can do this without leverage. But if you are getting into this sport to create an empire, you will not be able to do it without leverage.
In this case, do it while you can, acquire real estate at break-neck speed while you can, because there will come a time when you will necessarily have to back off…
Caveat: Just to make sure that we understand each other – what I described above is true in concept. However, it is important to comprehend that not just any old piece of real estate will accomplish these stated objectives. For many, many reasons — for which this is neither the time or place — PIGS won’t do!
What do you think? Is there a time and a place for leverage — and if so, when is that?
Leave your comments below!