The Power of Leverage (Cash Vs. Leverage)
Devin JamesPro Member
Developer · Orlando, FL · Member since 2018 · 502 posts · 306 votesThe Power of Leverage (Cash Vs. Leverage)
Most Popular Reply
Put both monthly payments in with a 7% interest rate(today's rates).
What's the math then out of curiosity?
18 Replies
I generally agree with your sentiment about leverage, but your example is really misleading. I'm ok with you ignoring the P of the mortgage payment, but excluding the Interest part of debt servicing is ill-advised.
To @V.G Jason's point, using different interest rate assumptions affects the returns substantially.
leverage is still useful, especially when you have opportunity costs that return higher than loan rates. However, that's a different analysis than what you're presenting.
- Developer · Orlando, FL · Member since 2018 · 502 posts · 306 votes1y
Quote from @Allan C.:
I generally agree with your sentiment about leverage, but your example is really misleading. I'm ok with you ignoring the P of the mortgage payment, but excluding the Interest part of debt servicing is ill-advised.
To @V.G Jason's point, using different interest rate assumptions affects the returns substantially.
leverage is still useful, especially when you have opportunity costs that return higher than loan rates. However, that's a different analysis than what you're presenting.
@Allan C. & @V.G Jason Yes, I can now see how this can be misleading. This post wasn't meant to be a all-case scenario. Its supposed to provide an example of the power of leverage. But I see how leaving out the interest costs makes a substantial difference. I appreciate the guidance!
Quote from @Devin James:
Quote from @Allan C.:
I generally agree with your sentiment about leverage, but your example is really misleading. I'm ok with you ignoring the P of the mortgage payment, but excluding the Interest part of debt servicing is ill-advised.
To @V.G Jason's point, using different interest rate assumptions affects the returns substantially.
leverage is still useful, especially when you have opportunity costs that return higher than loan rates. However, that's a different analysis than what you're presenting.
@Allan C. & @V.G Jason Yes, I can now see how this can be misleading. This post wasn't meant to be a all-case scenario. Its supposed to provide an example of the power of leverage. But I see how leaving out the interest costs makes a substantial difference. I appreciate the guidance!
It's not misleading, it's negligent. Without going to the amortization schedule (assume interest only payments), 7% interest on 480k, yields 168k in interest over the first 5 years. So instead of a profit of 64k, you have a loss of ~100k.
- Developer · Orlando, FL · Member since 2018 · 502 posts · 306 votes1y
Quote from @Peter W.:
Quote from @Devin James:
Quote from @Allan C.:
I generally agree with your sentiment about leverage, but your example is really misleading. I'm ok with you ignoring the P of the mortgage payment, but excluding the Interest part of debt servicing is ill-advised.
To @V.G Jason's point, using different interest rate assumptions affects the returns substantially.
leverage is still useful, especially when you have opportunity costs that return higher than loan rates. However, that's a different analysis than what you're presenting.
@Allan C. & @V.G Jason Yes, I can now see how this can be misleading. This post wasn't meant to be a all-case scenario. Its supposed to provide an example of the power of leverage. But I see how leaving out the interest costs makes a substantial difference. I appreciate the guidance!
It's not misleading, it's negligent. Without going to the amortization schedule (assume interest only payments), 7% interest on 480k, yields 168k in interest over the first 5 years. So instead of a profit of 64k, you have a loss of ~100k.
Is that with the home sitting vacant for 5 years?
Quote from @Devin James:
Quote from @Peter W.:
Quote from @Devin James:
Quote from @Allan C.:
I generally agree with your sentiment about leverage, but your example is really misleading. I'm ok with you ignoring the P of the mortgage payment, but excluding the Interest part of debt servicing is ill-advised.
To @V.G Jason's point, using different interest rate assumptions affects the returns substantially.
leverage is still useful, especially when you have opportunity costs that return higher than loan rates. However, that's a different analysis than what you're presenting.
@Allan C. & @V.G Jason Yes, I can now see how this can be misleading. This post wasn't meant to be a all-case scenario. Its supposed to provide an example of the power of leverage. But I see how leaving out the interest costs makes a substantial difference. I appreciate the guidance!
It's not misleading, it's negligent. Without going to the amortization schedule (assume interest only payments), 7% interest on 480k, yields 168k in interest over the first 5 years. So instead of a profit of 64k, you have a loss of ~100k.
Is that with the home sitting vacant for 5 years?
Probably, I just added it to your numbers. And that would be apt as you didn’t added rent to your cash buyer.
The thing about leverage is that it makes a good investment better, an average investment worse, and destroys you on a bad investment. what it doesn't do is take a poor investment (2.5% IRR) and turn it into a home run (26%irr) because you get killed on interest.- Real Estate Broker · Minneapolis, MN · Member since 2011 · 5k+ posts · 6k+ votes1y
You're all leaving out the #1 biggest impact/variable to buying all cash vs leverage....
Uncle Sam.
A big cash flow = a big tax bill.
And let's assume your an LLC on that property, so now it's changing your tax bracket and tax rate on your W2 income to boot. So your not only having to kick out say 32% of that cash-flow but now instead of 27% of your w2 income gone that's now up to 32% as well......
Or, you could have spread that $ around a bit with leverage, had 3 properties accruing equity and getting paydown via tenants $......
See, that's the BIG difference. It's not do "A" property with or without leverage..... It's do I use this $400k to get 1, or 4 properties. Do I have 1 asset appreciating or 4. Do I have 4 appreciating assets getting paid on via OPM or 1 "savings account" property?
The math is very VERY clear as it's a divide the size of the grand canyon..... Once do correct full math of the scenario potential.
- 1yJohn MorganPro MemberRental Property Investor · Grand Prairie, TX · Member since 2018 · 2k+ posts · 2k+ votes
Leverage your way to wealth. Don’t pay off your properties until you hit your financial goals and don’t want anymore cashflow.
- NH · Member since 2016 · 56 posts · 73 votes1y
Yes, leverage in real estate is the real wealth builder. Assuming this is a cash-flowing rental, the interest discussion is somewhat irrelevant.
I used a FHA at 3.5% down on a <600k triplex. Turned it into a quad, and it's now doubled in value since purchase 5 years ago. With leverage + principal paydown, my equity has gone from ~20k -> ~700k. Those types of returns are hard to get with other asset classes, without significant risk. Lets add in rent, lets say you get 4500 for it, which is just below the 1% rule. Expenses are generally (including taxes and insurance) about half of rent so you are left with 2250 to cover mortgage payments or put in your pocket, but lets round up to 2500. For easy, we'll do no rent growth (although we know it's not true). So you'll add 150k in rent over those five years)
So we can take our numbers above and add 150k collected in rent minus the expense.
So all cash,
Bought 500k, collected 150k in rent, profit = 214k or about 8.5%
On credit (3.5%) down
Bought 500k (20k down), collected 150k in rent, spent 168k in interest, so profit is 46k or about 46%. It's even better than you assumed.
Now lets say you only get 570 when you sell and only keep 2k in rent each month after expenses
Cash is 154k profit or 6.1% return
For your fha loan, you got 34k after paying off your loan, 120k in rent and 168k in interest, and you've now lost 14k or -14% per year from the whole ordeal.
The deal was supercharged when you it made 8.5% all cash to 46% IRR, but it destroyed your equity when it underperformed slightly (6.1% all cash).
Not I am making several approximations to make the math easier, for instance annual return is calculated as total return (%) divided by number of years, my spreadsheet when I analyze deals does the math.
Leverage in this case produces negative cash flow monthly unless sell the home after 5 yr. Investors are counting on home appreciating..by a lot to make the investment worthwhile, and assuming no rent gap w tenants. IMO, unless cash flow positive, it would be a dicey choice
- 1yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
Quote from @Peter W.:
Lets add in rent, lets say you get 4500 for it, which is just below the 1% rule. Expenses are generally (including taxes and insurance) about half of rent so you are left with 2250 to cover mortgage payments or put in your pocket, but lets round up to 2500. For easy, we'll do no rent growth (although we know it's not true). So you'll add 150k in rent over those five years)
So we can take our numbers above and add 150k collected in rent minus the expense.
So all cash,
Bought 500k, collected 150k in rent, profit = 214k or about 8.5%
On credit (3.5%) down
Bought 500k (20k down), collected 150k in rent, spent 168k in interest, so profit is 46k or about 46%. It's even better than you assumed.
Now lets say you only get 570 when you sell and only keep 2k in rent each month after expenses
Cash is 154k profit or 6.1% return
For your fha loan, you got 34k after paying off your loan, 120k in rent and 168k in interest, and you've now lost 14k or -14% per year from the whole ordeal.
The deal was supercharged when you it made 8.5% all cash to 46% IRR, but it destroyed your equity when it underperformed slightly (6.1% all cash).
Not I am making several approximations to make the math easier, for instance annual return is calculated as total return (%) divided by number of years, my spreadsheet when I analyze deals does the math.
FHA only works on plexs I dont think you can buy a sFR with a FHA loan right it has to be owner occ. ??? The main value of FHA and time is the 2 and 5 rule.. NO tax on gain. at least for me over the 50 years of owning primary residences selling them pocketing 500k each time tax free. Of course who was to know that Cupertino Palo Alto and prime areas of Portland would see such gains in such a short amount of time but One has to live somewhere right.. same properties bought in many other markets would not or NEVER go up 500k in the life of the property. RE is all about location location location.
At 7% interest, a $482,500 loan costs $3,207/month. Over 5 years, that’s $192K in payments. After selling for $600K and paying off the loan ($455K), you net ~$109K.
But your total cash outlay (down payment + payments) was ~$210K — so you lose ~$101K overall.
The best bet is not be over-levered or all cash. Be 1-1.33 DSCR, ideally 1.2 ish range with capex as a top line not bottom line item. 50% net cash flow= reserves, 50% net cash flow= investment #2. If I had to pick entirely levered, or entirely cash. I'd pick the former for path of progress areas, and latter for clearly primo areas.
Reality still needs to set. These prices are just so far from intrinsic that it's going to take a impeccable timing-- enough cash, a rate drop(due to a recession) & enough risk to assume something at 20% will work again. The reality is likely more cash down and this cannot be stressed enough--- buying right.
Take the 3 scenarios, with one solid house for $300k in Knoxville, TN. 20% down versus 100% down versus 1.25x DSCR. 7% interest rate, and capex as a top line item. No HOA.
1) 20% down- $2,100 PITI. $1,700 Rent. Negative -$400/mo.
Total down is $60k plus $5k closing costs, and since capex was top line item call it $15k. Total out of pocket= $80k
2) 55% down- $1,400 PITI. $1,700 Rent. Positive $300/mo. Net $180/mo after tax.
Total down is $165k plus 5k closing costs and capex being 15k.Total out of pocket- $180k
3) 100% down- $500 in T&I, $1700 Rent. Positive $1,200/mo. Net $800/mo after tax.
Total out of pocket is $320k.
Anyway you slice it, it's hard. Buying right is the only solution. Leverage isn't the most amazing strategy it use to be. Take into account the risk-- with all cash in one house, or even 55% down. Likewise, the risk for being completely over levered and not having sustainable cash flow to manage. I aim for option 2-- with a 28%-40% downpayment. I have found that's my really good middle ground.
- Real Estate Broker · Minneapolis, MN · Member since 2011 · 5k+ posts · 6k+ votes1y
Quote from @V.G Jason:
The best bet is not be over-levered or all cash. Be 1-1.33 DSCR, ideally 1.2 ish range with capex as a top line not bottom line item. 50% net cash flow= reserves, 50% net cash flow= investment #2. If I had to pick entirely levered, or entirely cash. I'd pick the former for path of progress areas, and latter for clearly primo areas.
Reality still needs to set. These prices are just so far from intrinsic that it's going to take a impeccable timing-- enough cash, a rate drop(due to a recession) & enough risk to assume something at 20% will work again. The reality is likely more cash down and this cannot be stressed enough--- buying right.
Take the 3 scenarios, with one solid house for $300k in Knoxville, TN. 20% down versus 100% down versus 1.25x DSCR. 7% interest rate, and capex as a top line item. No HOA.
1) 20% down- $2,100 PITI. $1,700 Rent. Negative -$400/mo.
Total down is $60k plus $5k closing costs, and since capex was top line item call it $15k. Total out of pocket= $80k
2) 55% down- $1,400 PITI. $1,700 Rent. Positive $300/mo. Net $180/mo after tax.
Total down is $165k plus 5k closing costs and capex being 15k.Total out of pocket- $180k
3) 100% down- $500 in T&I, $1700 Rent. Positive $1,200/mo. Net $800/mo after tax.
Total out of pocket is $320k.
Anyway you slice it, it's hard. Buying right is the only solution. Leverage isn't the most amazing strategy it use to be. Take into account the risk-- with all cash in one house, or even 55% down. Likewise, the risk for being completely over levered and not having sustainable cash flow to manage. I aim for option 2-- with a 28%-40% downpayment. I have found that's my really good middle ground.
Your assuming the person buying the investment property needs the net cash flow.
And that is a big assumption of who is investing, and the environment.
The fundamental reality is the "E-Z" market is gone, kaput, history.
This, much more normal environment, is back to one that the bar of entry is many times higher and stresses an investment as just that, investing and not purchasing paychecks.
For a true investor and investment, they will take the $400mnth paper loss every time. Because it's a write down/off that helps against the other incomes tax exposure.
And again, it's not a true loss, it's a paper loss. A true loss is buying a home for $100k and selling it for $50k.
A paper loss is payments going to debt paydown and equity accrual is not $ gone, it's money transferred.
And in truth that $400 is with consideration that someone else, a tenant, is paying $2,500mnth plus, kind of like how an employer contribution to a 401k works. Everyone seems to think those are awesome, an employer matching whatever tiny part. Well, what if an employer was willing to match your contributions 5:1 ???? Yeah, everyone would be jumping up n down about what a no brainer that is and plow every cent possible into it.
Ok, so why is it any different when a tenant will match our contribution 5:1, or 7:1, 10;1 etc ?????
Now I get it, the person reading this saying "but what about me, I can't afford another $400 mnth payment"..... Yeah, your not ready yet. Your 1st and foremost issue to solve is THAT, that you can't afford something as minor as a $400mnth expense. You need to change that FIRST. Because anything else, your NOT investing, your gambling. it's going to the roulette table with your grocery $ and praying it wins. DONT DO THAT.
And yeah, sorry that reality is what it is but welcome to the real world. If you really want a Lambo but all you can afford is a Pinto, it's not the auto industries fault, it's a you need to change your active income fault.
Yeah, I know, Guru said blah-blah-blah. They are paid to say that, literally, there selling memberships, think it through.
Your not an investor, or ready to invest, until you have capitol to invest. Investing is putting $ out there that could completely vanish and you still have a roof over your head, food to eat, bills paid etc..
Side hustles are the most under rated powerhouse of things. A business, that generates more active income. Wholesaling, that's one. If your a GC, flip, that's another albeit high risk one. Open a taco stand, uber, deliver pizzas it doesn't matter just get your head right and understand investing takes $, it is not some over night paycheck, nobody is out there selling paychecks at discount.
- Yes, I am.
Quote from @James Hamling:
Quote from @V.G Jason:
The best bet is not be over-levered or all cash. Be 1-1.33 DSCR, ideally 1.2 ish range with capex as a top line not bottom line item. 50% net cash flow= reserves, 50% net cash flow= investment #2. If I had to pick entirely levered, or entirely cash. I'd pick the former for path of progress areas, and latter for clearly primo areas.
Reality still needs to set. These prices are just so far from intrinsic that it's going to take a impeccable timing-- enough cash, a rate drop(due to a recession) & enough risk to assume something at 20% will work again. The reality is likely more cash down and this cannot be stressed enough--- buying right.
Take the 3 scenarios, with one solid house for $300k in Knoxville, TN. 20% down versus 100% down versus 1.25x DSCR. 7% interest rate, and capex as a top line item. No HOA.
1) 20% down- $2,100 PITI. $1,700 Rent. Negative -$400/mo.
Total down is $60k plus $5k closing costs, and since capex was top line item call it $15k. Total out of pocket= $80k
2) 55% down- $1,400 PITI. $1,700 Rent. Positive $300/mo. Net $180/mo after tax.
Total down is $165k plus 5k closing costs and capex being 15k.Total out of pocket- $180k
3) 100% down- $500 in T&I, $1700 Rent. Positive $1,200/mo. Net $800/mo after tax.
Total out of pocket is $320k.
Anyway you slice it, it's hard. Buying right is the only solution. Leverage isn't the most amazing strategy it use to be. Take into account the risk-- with all cash in one house, or even 55% down. Likewise, the risk for being completely over levered and not having sustainable cash flow to manage. I aim for option 2-- with a 28%-40% downpayment. I have found that's my really good middle ground.
Your assuming the person buying the investment property needs the net cash flow.
And that is a big assumption of who is investing, and the environment.
The fundamental reality is the "E-Z" market is gone, kaput, history.
That's almost the whole audience on this board. - Real Estate Broker · Minneapolis, MN · Member since 2011 · 5k+ posts · 6k+ votes1y
Quote from @V.G Jason:
Yes, I am.Quote from @James Hamling:
Quote from @V.G Jason:
The best bet is not be over-levered or all cash. Be 1-1.33 DSCR, ideally 1.2 ish range with capex as a top line not bottom line item. 50% net cash flow= reserves, 50% net cash flow= investment #2. If I had to pick entirely levered, or entirely cash. I'd pick the former for path of progress areas, and latter for clearly primo areas.
Reality still needs to set. These prices are just so far from intrinsic that it's going to take a impeccable timing-- enough cash, a rate drop(due to a recession) & enough risk to assume something at 20% will work again. The reality is likely more cash down and this cannot be stressed enough--- buying right.
Take the 3 scenarios, with one solid house for $300k in Knoxville, TN. 20% down versus 100% down versus 1.25x DSCR. 7% interest rate, and capex as a top line item. No HOA.
1) 20% down- $2,100 PITI. $1,700 Rent. Negative -$400/mo.
Total down is $60k plus $5k closing costs, and since capex was top line item call it $15k. Total out of pocket= $80k
2) 55% down- $1,400 PITI. $1,700 Rent. Positive $300/mo. Net $180/mo after tax.
Total down is $165k plus 5k closing costs and capex being 15k.Total out of pocket- $180k
3) 100% down- $500 in T&I, $1700 Rent. Positive $1,200/mo. Net $800/mo after tax.
Total out of pocket is $320k.
Anyway you slice it, it's hard. Buying right is the only solution. Leverage isn't the most amazing strategy it use to be. Take into account the risk-- with all cash in one house, or even 55% down. Likewise, the risk for being completely over levered and not having sustainable cash flow to manage. I aim for option 2-- with a 28%-40% downpayment. I have found that's my really good middle ground.
Your assuming the person buying the investment property needs the net cash flow.
And that is a big assumption of who is investing, and the environment.
The fundamental reality is the "E-Z" market is gone, kaput, history.
That's almost the whole audience on this board.And all the people going to a casino every day/week.... rubbing hand's thinking there gonna walk in with $100 and walk-out with $10k.....
Just because there is many people with a very incorrect mindset, it does not change the reality of what it all is.
Or how wrong and failure loaded that mindset is.
@Ying Tang
Thanks for you input which was easy to follow but it seems I am missing something. On one hand the OP is buying a a personal residence which makes your argument as well as the others true.
But how does cash flow come into the picture if it's a owner occupied residence? Or did the OP move after 1 year then converted it to a rental, which at that time would mean made payments for 1 year only so about $40,000 in payment but years 2-5, Tenants are making the payments. So that's $64K - DP-CC-1 year's payments no?
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