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Enhancing The Potential Benefits of Leverage
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Oct 2, 2005, 17:59
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You enhance the potential benefits of leverage whenever you find a way either to borrow at less cost or to increase the percentage of borrowed money you use in the transaction. For example, if you could acquire Property B with a mortgage loan at 6 percent instead of 8 percent, the interest on your $40,000 mortgage would then be only $2,400 a year. Subtract this $2,400 from your $5,000 income on the property, and you'd be netting $2,600, which is a 26 percent annual yield on the $10,000 you invested.
A second way to enhance the potential benefits of leverage is to borrow more - take out a bigger mortgage in proportion to your down payment. Let's imagine a Property C, also available to you for $10,000 down. Its operating income is $10,000 a year so the seller, logically enough, prices it at $100,000. But he's willing to carry back a $90,000 mortgage at 8 percent, the same rate charged by the owner of the $50,00 Property B.
Buying a $100,000 piece of property with only a $10,000 down payment sounds like a shoestring deal, doesn't it? But such deals are closed every day. They are perfectly sound for the buyer, the seller, and the lender. In the case of Property C, the leverage makes it even more attractive than Property B. Sure, you'd be paying more interest each year than if you bought B. You'd pay $7,200 a year (8 percent of $90,000), which seems an awfully big chunk of the $10,000 operating income. Your net profit would be only $2,800 a year. But that's a 28 percent return on your $10,000 equity - more than half a gain as much as if you bought the $50,000 property with a $40,000 mortgage, and almost three times as much as if you bought the $10,000 property for cash.
Of course, you could further heighten the leverage you were using by making an even smaller down payment. If you bought Property A, B, or C at the same price, with the same mortgage terms, but made only a $5,000 down payment, say, or just a $1,000 down payment, then the potential return on cash you invested would be even greater. But there's a limit to how small a down payment most sellers will accept. Most expect 20 to 25 percent, although many will sell for as little as 10.
Moreover, an imaginative buyer can sometimes find ways for a seller to benefit by taking a smaller down payment.
Negative leverage can put money in your pocket, however, if you make a big enough profit when you sell, exchange, or otherwise dispose of the property.
To understand the paradox of negative leverage becoming profitable, let's go back to the three hypothetical properties we discussed here. Whichever property you bought, we'll assume, you've upgraded it and managed it so well that its rental income and market value have gone up by 35 percent. Anyone following this method should be able to do this almost automatically. But of course repairs and upgrading cost money; let's say it cost 17 percent of your original purchase price, so your net gain is 18 percent.
When you sell the property, you'll pay a commission to the broker - perhaps 6 percent - and there'll be other costs involved in selling. Let's say the commission and other costs reduce your net profit on the sale to only 10 percent.
These figures would mean that when you sold Property A, which you theoretically bought for $10,000 in an all-cash deal, your 10 percent would equal $1,000 (plus whatever profits you pocketed from rents during the period you owned it).
If you made the same 10 percent profit in selling Property B, you'd end up $5,000 better off than at the start (again, plus or minus whatever income or deficit the property generated in the meantime). And the profit on the $100,000 Property C would be $10,000 - a full 100 percent return on your investment.
Now what effect would negative income leverage have on these figures? In acquiring a more expensive property, using a little negative income leverage (operating at a loss on borrowed money in other words) could ultimately bring you more profit than if you had paid all cash for a lower-priced property. In fact, the negative income leverage could have put you $800 into the red each year for as many as five years on the $100,000 property, yet would bring you an overall pretax profit as big as you could have made on the all-cash Property A deal.
This points up the principle that you're usually better off with a small equity in a high-priced property, even if it operates at a little loss, than with full ownership of a lower-priced property operating at a profit ¨C when you finally sell, that is. And profit on sales, not income from rents, is where real estate investors make real money.
Naturally, we're oversimplifying a bit. In practice there would be other factors to take into account, such as the timing of the cash flow, payments on the mortgage principal, and the impact of taxes.
One of the times when leverage can really hurt you most, rather than help you, would be when you sold a property for less than its purchase price. A 10 percent loss on a $10,000 all-cash investment would be $1,000. but a 10 percent loss on a $100,000 property bought with a $10,000 down payment would be $10,000. in the first case you'd lose one-tenth of your investment; in the second case you'd lose all of it. However, there is negligible risk of any loss at all on resale if an investor sticks to the principles we have been discussing. Just make reasonable allowances for unforeseen problems and contingencies.
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