What's 'Good' Leverage? Maybe Not What You Thought

“So, tell me about that deal you were talkin’ about last weekend. How’d it go?”

“Man, got some incredible leverage — just 10% down, owner carried a monster second, and get this — the interest is just 6%. No credit check, not nothin’. It closed Friday, and I’m jazzed.”

“Geez, sounds good, but with so little down, does it cash flow? I mean, I know ya got a smokin’ deal, but with the fix-up needed, and all that, are you sure it’s all gonna come out OK?”

“You amateurs just don’t get leverage, do ya? I mean, Holy Cow! 10% down! Even with the super temporary negative cash flow, and the up front fix-up costs, the low price will more than make up for it — especially when the market comes roarin’ back.”

“But I thought cash flow, appreciation, principle pay down, those sorta things was what made your investments profitable. No?”

“Well, yeah, but leverage is what makes it happen faster, and with a bigger bang. If you work at it awhile and become an experienced pro like me, you’ll see what I mean. Leverage is the name of the game — it overcomes everything.”

This’ll come as a shock to many, but learn this one concept, and you’ll have a shot at avoiding much heartache in the future. Leverage isn’t about down payment. At best that’s a secondary, though sloppy use of the concept. When it comes to investing, the knowledgeable investor knows when 50% down is world class leverage, and when 10% down sucks like a turbo-charged Dyson.

What? Huh?

Let’s look at what leverage really is.

Boiled down to it’s simplest terms, if your investment yield is higher than the cost of your borrowed money (Also lurking in the background is your down payment’s opportunity cost — gulp.), your leverage was positive. If the cost of money was higher than your yield/return? You had negative leverage. The down payment was never mentioned.

Borrowed money at 5.5% and your total after tax return was 4.3% annually? You’re hurtin’ for certain. Borrowed at 25%, but your return was 35%? Positive leverage BigGuy.

Don’t go away thinkin’ BawldGuy said down payment doesn’t matter — it does. Obviously, the more we put down, the more likely a given property is to cash flow, or cash flow much mo betta. I get it. But the big picture is what counts. It begins the day you close, and ends on the day you sell and/or exchange it. If your after tax return was greater than the cost of your money — do the happy dance. If not? The investment was a net loser — no way around it.

Borrowing money is a serious business for a real estate investor. Even if they’re operating on the spurious premise leverage is generated via the size of their down payment, they still know when it’s taken a wrong turn. This isn’t rocket science by any stretch. A forensic accounting ‘autopsy’ of a loser investment will illustrate why it went south. The yield was less than the cost of borrow money.

Borrowing money at 5% while yielding 4% doesn’t usually last very long. While your money is flyin’ out the window, I bet you’re not smilin’ about the ‘unbelievable’ leverage you got. Meanwhile, the guy who borrowed at 6% while making 7% is virtually living on the planet Happy Feet. See? Not rocket science.

Old School banks know how this works. Imagine you and I opened a bank together. We each invested a million bucks. After awhile we both had our million back and were workin’ entirely on ‘house money’. We pay depositors 1-3.5% on their money, with the agreement we can loan their money to real estate home buyers and investors. We pay an average of say, 2%, and lend it out at around 5%. It reminds me of the ol’ country boy banker who was asked how he become such an incredibly wealthy man. “Why shucks, it weren’t no big deal. I just borrowed at 2%, lent at 5%, and settled for my 3%.”

3% indeed. It’s all about positive leverage…or not. It ain’t about down payment.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.