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.\u00a0 Let me come right out and tell you that I am biased in this matter \u2013 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.\u00a0 Every technique and every negotiable term within my world of creative finance and acquisition exists for one of two reasons \u2013 either to make the deal more profitable, or two make it possible, or doable, in the first place.\u00a0 Leverage can do both!\u00a0 So, let\u2019s talk leverage\u2026<\/p>\n
Real estate investing, as it relates to acquisition of long-term income-producing property, is a cash-intensive game.\u00a0 Do you have cash?\u00a0 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?<\/p>\n
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.\u00a0 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.\u00a0 Since defeat is not an option, we are left with leverage.<\/p>\n
I don\u2019t know how much more plainly I can put this for all of the naysayers who oppose leverage in all of its incarnations.\u00a0 If you inherited money or are fortunate to be in high-paid professions which facilitate making fat down-payments on your real estate acquisitions \u2013 good for you.\u00a0 \u00a0\u00a0But, for those of us who are less fortunate, creative utilization of higher levels leverage is an absolute requisite \u2013period!<\/p>\n
But aside for allowing us into the game, leverage also makes our deals much more profitable as it relates to Cash on Cash return.\u00a0 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.\u00a0 Let us evaluate the Cash on Cash return in this deal based on three financing options: 25% down, 10% down, and 100% financing.<\/p>\n
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%. \u00a0Also, let\u2019s assume that the closing costs in each of the examples are wrapped into the financing.\u00a0 And finally, let\u2019s say that all of the units are rented on the day of closing and that there are no immediate delayed maintenance issues.\u00a0 Below is a rudimentary analysis of the cash flows in each of our examples:<\/p>\n
25% Down<\/span><\/b> 10% Down<\/span><\/b> 100% Financing<\/span><\/b> A quick consideration of the above will bring to light several interesting realities:<\/b><\/p>\n 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.<\/p>\n For all of my apparent \u201clove affair\u201d with leverage, I am the first to admit that you must be smart and very<\/em> well educated before attempting to utilize higher levels of leverage.\u00a0 Do not over-leverage the equity under any circumstances, though this may be tempting from time to time.\u00a0 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.\u00a0 Leave yourself a margin for error.\u00a0 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!\u00a0 The latter will allow you to weather the storms that inevitably will come your way!<\/p>\n 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!<\/i><\/b><\/p>\n Thoughts?<\/p>\n
\nPurchase Price:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $160,000
\nCash Down-Payment:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $40,000
\nFinanced Portion:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $120,000
\nCost of Money:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $720 (rounded off)
\nCash Flow:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $680\/month (CF = NOI \u2013 Cost of Money)
\n*Cash on Cash:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 21% (COC = Annual CF \/ (Down-Payment + Closing Costs + Repairs)<\/p>\n
\nPurchase Price:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $160,000
\nCash Down-Payment:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $16,000
\nFinanced Portion:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $144,000
\nCost of Money:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $864 (rounded off)
\nCash Flow:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $536\/month
\n*Cash on Cash:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 41%<\/p>\n
\nPurchase Price:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $160,000
\nCash Down-Payment:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 N\/A
\nFinanced Portion:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $160,000
\nCost of Money:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $960 (rounded off)
\nCash Flow:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 $440\/month
\n*Cash on Cash:\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Infinity<\/p>\n\n
\nQuestion<\/strong>:\u00a0 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?
\nFramed differently;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?\u00a0 For me personally, the answers are always YES and YES \u2013 you make your own decisions\u2026<\/li>\nIt\u2019s not all this simple:<\/h2>\n