She goes by many names: debt, financing, margin, or even the more archaic SPAN. For our purposes, I choose to call our temptress: real estate Leverage.
And temping she is.
In her warm embrace, you experience the joys of multiplying your returns, seemingly for free.
Once you’ve joined with her, you’ve also welcomed her bedfellow: Risk. Hidden though he may be, he’s always there. The more intimate you become with Leverage, the more intimate you become with Risk. It’s Risk that leads to your downfall.
In order for Leverage and Risk to take control they rely on misdirection and confusion. Let’s attempt to right some misconceptions.
How I Bought, Rehabbed, Rented, Refinanced, and Repeated for 14 Rental Properties
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Understanding Our Market Keeps Risk at Bay
All of us should become an expert on our investment area. It’s a surefire way to find amazing deals.
However, that market knowledge doesn’t shield us from Risk.
The incarnations of Risk to worry about are unforseen catastrophic events like:
- The largest employer goes out of business
- The local university cuts its enrollment
- Bankers underestimate the risk of credit default swaps and sideswipe the entire economy
- The Godfather make you an offer you can’t refuse
We can’t plan for these, other than to leave ourselves enough wiggle room so our operations don’t implode if one of them happens.
When investing, you should be a pessimist. What if your area sells off 10%? What about 20%? If the answers get your pulse racing, consider reigning in your real estate Leverage.
Confusing Real Estate Leverage and a Good Deal
All real estate investors should calculate a deal’s cash flow and cash on cash return. Be wary though, if we use these exclusively, we’re opening the flood gates to Leverage and Risk.
Sure, our numbers might show a 200% cash on cash return, but how intimate are we getting with Leverage and Risk? If your debt ratio is 50:1, a 20% drop would wipe out 5 years worth of income. 10 years if it’s 100:1.
Let the deal make the deal. Does it make sense when we examine debt free metrics like capitalization rate and price comparisons? If so, then we can use conservative financing to give our returns a healthy boost.
Real Estate Investing is a Good Way to Get Leverage
Maybe you’ve decided you love Risk and want as much Leverage as possible. Well, if it’s worth doing, it’s worth doing right.
Why not open a stock margin account? Loans in under a minute.
How about buying futures? 250:1 debt ratios and no real limit on investment size.
Even better, let’s sell a boat load of out of the money puts. It’s a bit tricky to calculate but the equivalent debt ratio could be over 1000:1!
These options are fast and effective. They’re also cheaper than real estate Leverage. There are no pesky costs like loan origination fees, appraisals, prepayment penalties, or high interest rates.
If you’re dedicated to get rich quick or die trying, do it in style.
Leverage is the Only Option
The argument goes that if you don’t have any money, you should use large amounts of Leverage to get started.
Why? What’s the rush? Why don’t you save money first? If you buy a bunch of real estate without money and things go pear shaped, you wind up with even less money and a migraine.
Wrap It Up
Most of us are striving to build a steady income stream so we can choose how we spend our time (retire).
It’s tempting to turn to Leverage’s warm embrace to help us in this quest. The trouble is her bedfellow Risk, who can quickly scupper our retirement plans.
Don’t let real estate Leverage take control, rebuff some of her advances.
I know it’s cliche, but it’s a marathon, not a sprint. Save your money and invest it responsibly.
Photo: Martin Whitmore