Real Estate Leverage: The Temptress

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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.

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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.

Real Estate Leverage

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

About Author

Kenneth Estes

During Kenny's decade in finance he bought many single family rentals in rural areas, as a hobby. Along the way, he talked some brave souls into joining him as investors and recently retired from finance to take his hobby to the next level. Find more by and about Kenny on his personal blog and his recently created twitter account!

22 Comments

  1. Chris Clothier

    Kenny –

    Nice article! I liked the title a lot and you summary at the end is really good. A lot of us have written on this topic, but the reality is that it can never be talked about enough – especially for new investors. I think describing leverage as ‘The Temtress” is very appropriate – many of us have cautionary tales to tell of when she bit us on the back side!

    I think your spin is a good one – thanks for writing.

    Chris

  2. Great article and word of warning.
    I personally love debt, but it is not for everyone. I am curious what you think a good debt ratio is for investors?

    I think the key to using debt wisely is preparing for the worst case scenario and making sure you can make it through. I also don’t finance anything to the hilt.

    • Kenneth Estes

      For my holdings, I’m cheap and don’t want to pay Private Mortgage Insurance. So, assuming it has strong cash flow, I’ll go up to the magical 80% Loan-To-Value.

      When it comes to the investor money entrusted with us, I’m a lot more conservative. We currently have no financing (but still manage solid returns as you can see in my personal blog). We’re going to take on some debt in the near future but I don’t plan to break the 60% LTV mark.

    • All investment are not the same. Look at triple net Walgreens, in 2010 you could get 105 of purchase, not a typo, check CTL loan on Google. My main concern was to get cash flow, needed to put money down, else negative cash flow. So, went 18% dn to get 4.50% cash on cash, to be comfortable to get retirement income. Risk here is minimal, since Walgreens guarantee 25 Yrs lease, that could extend to 75Yrs!!!

  3. Kenny,

    You make my blood boil, but the fact is that I see a bit of you in the guy staring at me in the mirror 🙂

    Cash on Cash means nothing – agreed. Cap Rate is everything – agreed again. Saving doesn’t work for most of America, and you know this Kenny. It is impossible to save earned income unless there is an awful lot of it – structurally impossible…

    Aside for this, I am with you. Thanks for writing this.

    Ben

    • Kenneth Estes

      Thanks for your comment Ben.

      Glad we’re not too far opposite one another.

      My general take is similar to Brandon Turner’s. Real estate investing is a job. It takes many hours to buy a home and manage it. I did a back of the envelope calculation on my personal blog entitled “Why Real Estate Gurus are Full of It,” which implies that to make a good initial investment you’re looking at 336 hours of effort. Just to find a house! That doesn’t include the hours spent learning how to invest in real estate.

      If you have 2 full months of 40 hour weeks to spare, then you can take a part time job and build some savings. Less risk and a more certain way to economic freedom.

      Thoughts?

      Cheers,

      Kenny

  4. Hey Kenny,

    I appreciate the article, for sure. I think you are spot on about the leverage thing. The only thing I’d debate is your assertion of “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.”

    So, let’s look at it from this standpoint: my life.

    I was working for $11/hr at a group home. 40 Hours a week resulted in roughly $1700 per month in income, with $1300 left over after taxes. Rent was $600 per month, plus utilities, plus food, gas, clothing, etc. In the end, I’m left with maybe $100 per month for savings.

    Plus the job was kinda crappy.

    So, saving $100 per month, I would save approximately $1200 per year. If I saved for 10 years, I would have $12,000 (well, probably more like $20,000 with the interest I would be recycling.)

    Okay, now I’ve worked a crappy job for 10 years and I have 20,000 to invest with. I put 20% down on a investment house, and I now make $250 per month in cash flow. Combine that with the $100 per month in income I’m making – I’m at $350 per month I can now save.

    I work the crappy job some more, and save for 5 more years, and now I’ve got another 25k to invest in another rental house.

    Okay – I’m building wealth. Awesome.

    But I’ve been stuck in a crappy job for 15 years that I hate. And if I keep saving at this rate, I’ll probably be a millionaire by the time I’m 62. The american dream! I can now retire and relax.

    But then I had a heart attack and died at 61 1/2.

    Ugh – all that work for nothing.

    On the other hand – had I taken some risks, leveraged more, bought smarter – I could quit my job at 21 years old and muddle through a few tough years learning in real estate. I might do some bad deals and creativity would force me to change. Maybe I’d lose some money. But it would be MY life, not some crappy $11 an hour job. I’d love every second – even the hard parts. And leverage is what would make it possible.

    So that’s the hurry. It’s not about becoming a millionaire. Any average Joe in America can become a millionaire over time. It’s about living life NOW. And that’s why I flirt, maybe a little too much, with Lady Leverage and her bedfellow Risk. 🙂

    Thoughts?

  5. Great article Kenny. @Brandon Turner, you also make a compelling argument. However, the one weakness in your argument is that without an outside source of sufficient funds to put down on a property and have for a rainy day emergency fund if repairs/capex is required for a property, then disaster will strike. It is very tough to lose money in real estate, if you have the staying power for a long term hold (barring war or other unforeseeable disasters that we mortals have no control or influence over). So, if you can find an investor to spot you the first $25K as per your example to be your partner, you are well on your way of quitting your crappy job, having a real estate investment business and having the proper grounding (i.e. downstroke) to make sure that some blip doesn’t kill you off because of too much leverage.

    You asked for thoughts, so those are mine.

    • Better yet, Ira – why not borrow the entire 100k, or 200k, or 500k from a private source or a partner and buy the thing for cash – force the valuation, and refi at 70% LTV to get all or most of the money out, and substitute, blanket, or slice and dice other collateral for what is left…

      I buy with $0 out of pocket all day long. It is easy – all of it, but not before you are ready and not before people deem you to be ready. So, your way can work in principal, but is very difficult to attain for a newbie…

      • Kenneth Estes

        Ben,

        Thanks for the comment!

        Your argument seems to generally agree with mine. You might be able to get full leverage, but not “as a newbie”. One more reason you should build some savings before you start investing in real estate.

        Cheers,

        Kenny

  6. Yes, yes, and yes again. Brilliant post, couldn’t agree more. And thats all from an individual point of view, not even touching on the broader picture (idea for a follow up article?)

    In a nutshell, (and only in my opinion, of course, which is clearly in the minority globally), spruiking yet more debt to a world leveraged to the gills is a complete and utter fiasco of carelessness, exploitation and irresponsibility – which the “big players” seem to be, amazingly, beyond belief, doing all over again (perhaps due to the fact that they’re confident they’ll be bailed out yet again, at the expense of the masses).

    As for Brandon’s real-life example – instead of being stuck in a job you don’t like for 15 years, how about going to, god forbid, community college or some other study arrangement (I do believe there are affordable ways to pull that one off, even in the US), so you can land a better and higher paying job, and spend not 15, but 4-5 years instead, improving your employment status to the point where you’ll be able to save more, or at least take on slightly less debt, in more reasonable terms & conditions, rather than seek the (seemingly) “quick and easy” way out of the $11/hr job that sucks so much?

    Not to mention the fact that, if more of us were to follow that path, the economy would most likely be in a better state, and that $11/hr job might be paying better, or better paying jobs could more easily be found.

    Another point to add is that, no matter what the current conditions in your back yard may be, there’s always somewhere in the world where affordable deals can be found – your $20-30k may just be all you need to purchase a complete property (or a very large portion of one) somewhere else in the world, if you do a bit of DD (and no, I don’t mean in Detroit – we deal in japanese real-estate, where this is still quite possigle, and all of our clients are cash buyers – but there are other places too).

    But no. We all want the “quick and easy” path to “quick and easy” money – never learning to look beyond the immediate to what this does to the world around us – which, time and time again, comes back to bite us on the bum, in ever shortening cycles (“instant karma”, as Lennon put it, is becoming more and more instant, as the worlds economies and currencies become more and more intertwined on a daily basis, thanks to technology).

    With you 1000%, Kenny. Keep preaching the word. 🙂

    • Kenneth Estes

      Ziv,

      Thanks for the comment. You brought up some amazing points that I hadn’t properly tied to real estate investment.

      When it comes to what you said the phrase, albeit cliched, “I couldn’t said it better myself,” comes to mind. 🙂

      Cheers,

      Kenny

  7. Kenny – just started ready your articles and i love them. I get on BP every so often (well at least once a week), and i could never understand why no one would come on here and mention leveraged futures/ options/ etc compared to real estate leverage. Well i realize its a real estate website so there, i guess i answered my own question.

    As you have mentioned, having experience and relationships makes a huge difference in the RE business as any other and the get rich quick is basically a lotto ticket.

  8. The basic premise of this article is wrong.
    Kenny argues that it is less risky to buy a property and put 20% or 40% down rather than getting 100% financing because the property value could drop 10 or 20 percent or more due to circumstances outside the investors control.

    This is not true the risk is the same in either case but who takes the loss is different if you are forced to sell the property after the value dropped. If the property drops in value and you are 100% levered the bank takes the hit and your credit is ruined, if you put 20% down you loose your portion of the investment and your credit may be saved but the money is still lost it is just you that lost it.

    The variation in the property value is not the risk, the variation in cash flow and the ability to hold the property is the risk. If you put more down you have lower leverage and will have higher cash flow and presumably if you save it a better chance to make it through hard times. But if you cash flow well at 100% leverage it could be a lower risk investment as you don’t have your money at risk.

    I imagine Kenny would agree and has a great understanding of managing risk in terms of equity, cash flow and the final rate of return but simplifying the statement to “leverage is a temptress” is just to broad.

    Sean O’Toole makes the point that 100% leverage on a 2 cap property and 100% leverage on a 20 cap property are completely different. I’m sure we could all agree 100% leverage on a 20 cap property would be safe. It gets even more complicated though when setting your business plan and investment criteria with the rough fact that low cap rate properties tend to appreciate more and high cap rate properties in tougher areas or horizontal markets tend to appreciate less. I believe over the long run that property appreciation in single family investing usually dwarfs your returns on long term cash flow.

    Dave Lindahl gives a holy trinity on hold properties of cap rate 8+, Debt Service Coverage Ratio 1.6+ and cash on cash 12+. It didn’t really click for me before but having a good cap rate on a no cash stuck in deal is still really important to managing risk. The other thing most on this site due but wasn’t mentioned in the article is forcing equity by buying cheap or improving the property and even from better management and improving cash flows. Those are value added through skill not just $ down which lowers you risk on an investment.

    The point in the article I do take to heart, manage risk and leverage so I don’t go broke and loose it all.

    • Kenneth Estes

      Thanks for the comment Blake.

      Also, thanks for agreeing with me. Whilst you started out with a strong statement, the rest of your comments are actually arguments in favor of my article:
      – You run the risk of entering bankruptcy and ruining your credit if investing with no money goes south. As opposed to solely monetary risks.
      – The percentage loss is much higher with poorly performing investments with high leverage.
      – You have to look at debt free metrics (like cap rate) and then use conservative leverage. Depending on how good the deal is (bought it for 10% of value) that could very well be no money down.

      You’re correct that one of my examples solely focuses on the absolute number loss and that would be the same in both cases. Although the percentage loss is greater with NMD. Unless you’re thrown into bankruptcy. Perhaps you thought I was stating the only Risk was monetary? In which case yes, I probably could have highlighted personal risks.

      One point I do disagree with you on is “I believe over the long run that property appreciation in single family investing usually dwarfs your returns on long term cash flow.” This topic is indirectly analyzed in my blog “real estate vs stocks.” https://www.biggerpockets.com/renewsblog/2013/07/17/real-estate-vs-stocks/.

      If you look through those graphs it’s the cash flow, and reinvesting the income, that creates the most long term value. If you want to invest for appreciation, don’t buy real estate.

      Thanks again,

      Kenny

  9. While it is wise to always be aware of the risk you take when you use debt/leverage, I respectfully disagree with your reluctance towards it. It is true that people, all too commonly, abuse debt and overdo it, but when its used with responsibility and basic math, it can work tremendously in your favor.

    I’m a big fan and supporter of Kiyosaki’s views on debt. As he says, time is an asset even more valuable than money because you cannot get time back. therefore, when you’re building your empire and on your journey towards financial freedom, debt can be a huge tool in getting you to your destination much quicker.

    It’s not much different from other types of leverage, for example, the difference between trying to build a business by yourself or by hiring good employees.

    To quote Kiyosaki, ask yourself how long it would take you to save $1 million, then ask yourself how long it would take to borrow $1 million.

    It’s no coincidence that many real estate investors (big and small) use debt to grow their business, and its no coincidence that the biggest moguls and largest companies use debt to grow their businesses everyday. Entire markets exist because of its necessity and benefits.

    It’s especially wise to use debt for investing in real estate because the tangibility of real estate is solid collateral for getting you lower interest rates.

    When in doubt, you don’t need to rely on opinion or emotion – just simply crunch the numbers, and if they work, then its simple as that. Just my 2 cents 😉

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