It’d be hard to be around the real estate investing world and not have heard quite a bit about leveraging. What is leverage and in what ways can it help you as an investor?
According to Investopedia, leverage is:
The use of various financial instruments or borrowed capital to increase the potential return of an investment.
My bet is that the way in which leverage has been most talked about in your real estate venture has been in terms of borrowing capital. Borrowing capital is absolutely a key concept in REI, but it’s not the only way leveraging can help you through your investing career.
The reason leverage is such a big concept in REI is because it can be hugely beneficial for an investor. To elaborate on that, I’m going to explain the two different types of leverage that I have found to be of the greatest benefit throughout my investing career. The first type is probably quite obvious—and the second type may not be so much.
The 20 Best Books for Aspiring Real Estate Investors!
Here at BiggerPockets, we believe that self-education is one of the most critical parts of long-term success, in business and in life, of course. This list, compiled by the real estate experts at BiggerPockets, contains 20 of the best books to help you jumpstart your real estate career.
The Two Types of Leverage
Leverage can encompass a wide variety of things, even outside of REI. Because I watch a lot of dramatic dramas, I know that blackmail involves a huge amount of leverage! The person who blackmails the other person has all the leverage. That means they have the power because they have the thing that can get the other person in trouble. Leverage is extremely handy to have, no matter what it is. I don’t personally condone leveraging via blackmail, but I do condone leveraging in REI.
The two most powerful ways you can have leverage in REI are:
- Borrowing capital
This is the most obvious one, and if you’ve studied REI for more than about five minutes, you probably already know how this works. A lot of people call this “other people’s money” (OPM). There are even books that exist specifically to talk about the use of OPM. The reason it’s been written about and the term is so common is because OPM has made a lot of big-scale investors very rich. There is a lot of power in using OPM.
To be very clear, there is a lot of power in using OPM, but there are a lot of investors who are not comfortable using OPM or maximizing leveraging when it comes to capital. You should absolutely decide whether you are comfortable leveraging money for your investments or not. It’s completely OK if you aren’t comfortable with it, and it’s completely OK if you are comfortable with it—as long as you are educated on the risks and how to best mitigate getting yourself into any pickles with it. If done incorrectly, leveraging money can be dangerous to you financially. If done correctly, however, it can greatly increase the returns of your investments.
There are several ways to get OPM.
The most widely used OPM is bank loans. In this case, the bank is the “other person.” Specifically for the case of residential properties (single-family homes, duplexes, triplexes, and fourplexes), mortgages are the common bank loans. There are several types of mortgages. The conventional mortgage is the standard one, requiring a minimum of 20% down. Then there are variations such as the FHA mortgage loan, which requires much less of a down payment, but you can only get an FHA mortgage if you live in one of the units initially. You will also have to pay the extra PMI fees each month on top of the principal and interest.
Another type of bank loan outside of mortgages is hard money loans. Hard money loans are often used in flipping. The major difference between a mortgage and a hard money loan is the term of the loan. Mortgages can be spread over 30 years, and hard money loans can range from say six months to two years. Because of the short term of the hard money loan, those wouldn’t be practical for buying a rental property you intend to hold for the long-term. That’s why hard money is used oftentimes in flipping—flipping is a short-term project (hopefully).
For commercial investments, residential mortgages aren’t an option, but instead you would need to talk to a commercial lender for a commercial-specific loan.
Private lenders also exist who can lend in similar ways to banks. Private lenders are handy for people who don’t qualify for bank loans—which can be a lot of people! The downside to private loans is the required down payment can be pretty high and the interest rate is typically much higher than a mortgage.
The other option for OPM is exactly the “P” in “OPM”—people! Forming a partnership with someone on a deal, for example, is a way to leverage money. I have used a partner on a lot of my properties. Check out “How to Structure a Partnership for Investing in Rental Properties” for details on the structure I used with my partner. In this structure, I am leveraging my partner’s money to buy the properties. Because I leveraged his money and brought him in as a partner in the way that I did, I literally make infinite returns on our properties, as I bought them with no money down. The only way to buy anything with no money or little money down is through the use of leveraging.
For more information on how leveraging money changes the returns you will see on a property, check out “Leveraging vs. Paying Cash for Rental Properties: A Look at the Infamous Debate.” Also in that article, you can find more considerations to think about when deciding whether you are comfortable leveraging OPM for your investment properties or not.
This one is a type of leverage I don’t think people really think about much. It’s certainly not as widely understood as OPM, but I do know that leveraging the power of having people behind you as you invest can be hugely valuable.
Think of just your run-of-the-mill networking event. If you go to one and you make connections with people, either for jobs or hobbies or friends, you are leveraging other people through their connections. That’s just about the most simple example of having people as leverage I can think of.
But what about in REI?
Because I work with turnkey rental properties, I can best give you an example of the power of people as it has pertained to my turnkey investing career.
If someone is in the market to buy a turnkey property (through a turnkey company, not just a random property that is of turnkey status), they have two choices of whom they work with to buy the property. They can buy directly through a turnkey provider—the company who buys the distressed property, fixes it up, places a tenant, and has property management setup to handle the property—or they can buy through a turnkey promoter, which is a company that makes recommendations for various turnkey providers they suggest working with. (Sorry, the words “provider” and “promoter” are so close, so you may have to double-check which one I’m talking about.)
Turnkey providers have the properties, and turnkey promoters “promote” various turnkey providers. To make it less confusing, I’ll refer to turnkey providers as turnkey sellers for now. Ultimately, you still buy the property through the turnkey seller, even if you work with a promoter, but the promoter is the person you will end up communicating with more and getting recommendations from. Oftentimes, they will help handhold you through the buying process with the seller. To me, there are several reasons why working with a promoter over the seller directly is a much smarter thing to do, but for now I’m just going to explain the leveraging concept as it pertains to this situation.
Let’s say an individual investor wants to buy a turnkey property and they go straight to a direct turnkey provider (seller) and buy a turnkey property. Let’s say the property goes belly-up somehow. If the turnkey provider the investor bought from doesn’t have much of a conscious, they may just say sorry when the investor goes to them to explain what is happening. The seller isn’t on the hook for anything legally, most likely, so they don’t really have to do anything as far as helping if they don’t want. In their minds, irking off and therefore losing that one investor who bought one property isn’t going to hurt their business. It’s unfortunate any company may think this way, but it’s also reality. So the individual investor who brings minimal buying power really doesn’t have a lot of sway fighting against a company on the behalf of their belly-up investment.
What if the investor instead buys through a turnkey seller that they were introduced to through a turnkey promoter? So the promoter introduces the investor to the seller and they buy a property. Let’s say the property goes belly-up, just like it did the other example and the investor approaches the seller to explain the problem. Let’s say the seller gives just the same “sorry” and lets the investor be on their way without helping them. The difference this time is that the seller hasn’t just irked off the individual investor. As long as the investor tells the promoter (who introduced the investor to that seller), then the promoter may likely go knocking on the seller’s door. If the seller sticks with the same “sorry” about the property, they are no longer just risking losing one person’s minimal buying power; they are risking the entire buying power that the promoter brings to them. Promoters can bring hundreds of buyers to a single turnkey seller, which equates to millions of dollars of business. If the turnkey seller so blatantly screws over that investor and it irks off the promoter and the promoter therefore pulls their business (which I have seen happen), the seller could lose an extremely significant amount of business.
See the difference in buying powers there? The individual has minimal buying power, but the individual who is represented by the promoter has extremely high levels of buying power. While they aren’t the one personally with all the buying power, they are attached to the larger amount of buying power. The more the buying power in any transaction, the more people tend to behave. No smart company of any kind would risk losing their clients who hold the most buying power.
If you show up to any real estate transaction with millions of dollars of buying power attached to you, you have leverage. People are less likely to mess with you, they are much more likely to behave around you, and you hold the power because they are aware of the risk of screwing you over.
That is leverage.
What You Can Leverage From Other People
In the case of the turnkey scenarios, there is no official guarantee for if you work with a promoter, but I have seen on more than one occasion a promoter making things right with the investor if things go wrong. I can’t tell you how many times I’ve seen it. It’s nothing in writing, it’s nothing guaranteed, and it’s not an official rule with the turnkeys, but I’ve seen it happen enough to know that there is certainly an unsaid level of leverage you bring when you go in with an entourage behind you.
If you show up to any room with an entourage (a credible entourage hopefully), you hold some power. If you show up to any room as a single individual, it’s doubtful people will think twice or care about you.
That is the power of leveraging teams. When you work with teams, you are more likely to get further faster. In REI, I believe the two most powerful things you can leverage from other people are:
- Buying power
I’ve already discussed buying power and why it’s handy. Knowledge is probably obvious, at least in the sense of having as much of it as you can to help you succeed. Leveraging knowledge from other people is huge just for the sake of gaining knowledge, but it’s also extremely useful in making your knowledge-gain more efficient. Why reinvent the wheel if someone has already done it? Piggyback off what others have already figured out. Leverage that knowledge.
Related: How to Minimize the Wholesaling Competition in a Hot Market by Using Leverage
Going back to the example of the two paths for buying turnkeys, one of the most common questions I hear from investors looking to buy turnkeys is, “How do I know which company I can trust?” Quite the fair question! What people don’t realize is how many factors, both obvious and not obvious, can determine the quality of a turnkey provider. Learning how to identify all of the red flags of turnkey providers is actually extremely difficult! How are you, as the individual investor, going to learn all of that and make sure you implement it right in order to decide on which provider/seller to work with? You can certainly try, but if a turnkey promoter specializes in doing exactly that and has way more experience doing it, why not leverage their expertise for your own purchases?
That is leveraging knowledge.
Buying power leverage and knowledge leverage are two huge ways to utilize leverage with people. The caveat, of course, is that you need to ensure you are working with good people who know what they are doing. If you can identify those people, leveraging people is huge. I’ve seen it change the game not only for myself, but for many other investors as well.
There you have it—two insanely powerful ways you can use utilize leverage in the REI world.
Experienced investors, in what ways have you best leveraged in your investments? Maybe you’ve done it in way that I haven’t mentioned.
I’d love to hear about it!