Real Estate Investors – Are You a Bug In Search of a Windshield?

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I’ve been that bug on the windshield — three times. Only once was it due to outside forces — a politically powerful county supervisor wanted nobody in his fiefdom to prosper but him. We were dead in the water from the get-go. A lesson learned. The other times were due to me defying what I’ve come to call investment physics. Though certainly you could categorize my approach as OldSchool, investment physics knows no ‘school’. They work every time they’re tried — like gravity, either for, or against us.

Gravity is a part of our daily lives. We all have a healthy fear of it in the right circumstances. We might act crazy on a diving board three feet above the water in our backyard pool, but put us on the roof at a downtown penthouse bar, and crazy doesn’t enter our thought process as we peer over the edge, 30 stories down.

Same gravity — different consequences — same law of physics.

Leverage is a lot like gravity. It works every time it’s tried — one way or the other. Also like gravity, it doesn’t care which way it’s utilized — it just works. Gravity never, ever makes us fall up when jumpin’ off the top of a five foot fence onto the ‘soft’ grass below. I know that from personal experience — and my Superman cape helped not one iota. 🙂

Problem is, unlike gravity, the consequences of which most folks can at least accurately explain, most investors think the primary definition of leverage has to do with the size of their down payment on a  piece of property. “I got some great leverage on this one. $0 down!”

Watch out for that….splat!…….windshield.

When investing in anything, real estate included, down payment isn’t leverage, nor does the size of the down payment indicate whether or not a particular investment will be successful or not. Sounds obvious, doesn’t it? But apparently not, as legions of self described investors have bitten the big green weenie as a direct result of what’s known as negative leverage. I speak from personal experience. Ouch.

Never heard of it? Don’t feel bad, most haven’t.

Positive Leverage: When the return on invested capital is greater than the cost of borrowed money.

Negative leverage is, of course, the opposite. This surprises people, but we can all go back in time to a loser investment, do the numbers, and see this particular law of investment physics illuminated. “Oh, man. I borrowed hard money at 13% and the dang house only returned 7% — no wonder it was a loser.”

What this means is that a deal calling for 50% down can end up as the best leveraged investment you ever made, while the 0-20% down deal — not so much. Again, don’t come away thinkin’ the down payment is the deciding factor, cuz it isn’t. It’s just a factor along with all the others which you, as an investor analyze when choosing which deal to take.

A Captain Obvious statement: Most of the time the return is less than the cost of our borrowed money cuz we either miscalculated the ‘built-in equity’ or projected appreciation that was, um, a no-show. It can also sneak up on us when we underestimate operating expenses or overestimate rents — or participate in Murphy’s Bonus Round by doing both. (Guilty as charged.)

This ruthless law is why, when doing serious analysis of potential deals in today’s market, the elimination of appreciation is critical. The same goes for buyin’ property at ‘impressive’ discounts — don’t eliminate them — just keep in mind it’s only impressive if you’re correct. Get your own boots on the ground when deciding rents and operating expenses. Don’t believe anyone, or anything but you’re own lyin’ eyes ‘n ears. 🙂

Most new investors think the reason they use ‘other people’s money’ is to ‘leverage’ the little money they have. They often learn the hard way that the cornerstone assumption of borrowed money is that the use of that money will generate a  return exceeding the cost of that money.

The lesson I learned from violating this law — twice mind you — was simple as pie.

$0 down with borrowed money at 2% interest is a huge loser when the property’s return is 1%. Negative leverage. Yet a 50% down transaction with borrowed money at 20% interest with an ultimate return of 25% is a winner. Positive leverage.

This is what guys like Peter Giardini and Richard Warren are teaching constantly.

Listen to them and prosper. Don’t be a bug in search of a windshield.

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