Leverage
By Robert Prouty and Darrell Roberts
Real estate is the only major investment vehicle that allows an investor to acquire ownership with very little money down. By using or leveraging “other people’s money”, an investor can highly amplify investment returns and control more assets that work for him – the secret of the wealthy.
Leverage is a term describing borrowed money used to acquire an investment. When an investor places a loan on a property – he is considered to have “leveraged” the property. When used correctly, leverage will benefit the investor by allowing him to use less equity to purchase the property thus increasing the investor’s purchasing power. Leverage will also increase the investment returns.
Example 1: Assume an investor has $2,000,000 of equity to invest into an income producing apartment property. He knows that he has to put a minimum of 20% equity into a property. How much property can he purchase? The answer is that the investor has many options.
Option #1: The borrower can invest all $2,000,000 of equity into one property and not obtain a loan (i.e. no leverage or “all cash”). By doing this, the investor is limited to purchasing a property that only his equity can buy.
Option #2: The borrower can again invest all $2,000,000 of equity into one property but obtain a loan (i.e. leverage the property). Assuming the loan is 80% of the purchase price; his $2,000,000 could purchase one $10,000,000 property.
These two options can be illustrated in the chart below. Notice that when the equity as a percentage of the purchase decreases the investor’s purchasing power increases.
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Option #1
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Option #2
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Equity
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$2,000,000
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$2,000,000
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$2,000,000
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$2,000,000
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Loan as % of Purchase
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0%
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25%
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50%
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80%
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Equity as % of Purchase
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100%
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75%
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50%
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20%
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Purchase Price
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$2,000,000
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$2,666,667
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$4,000,000
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$10,000,000
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The borrower also has two other options with his $2,000,000 of equity.
Option #3: Suppose the investor wants to diversify his holdings and does not want all $2,000,000 in one property. He can choose to purchase several properties with his $2,000,000 investment. Assuming the loans would be 80% of the purchase price, the investor could purchase: (a) two $5,000,000 properties, (b) one $4,000,000 property and one $6,000,000, (c) ten $1,000,000 properties, etc. The borrower can buy as many properties of various sizes until the equity is gone.
Option #4: The final option for the investor would be to purchase a property but with low leverage. If the maximum LTV allowed by the lender is 80% and a borrower chooses a 60% loan (or some LTV below the maximum), the property is considered to have low leverage. Similar to Option #3, the borrower could purchase as many properties he wants under different loan scenarios. However, with low leverage, his has less purchasing power. For example, assuming the borrower wanted a loan for only 50% of the purchase price, the borrower could purchase a $4,000,000 property.
Leverage can be used in a variety of ways to assist an investor to meet his investment criteria. Unfortunately, leverage can also become dangerous. The danger comes when an investor seeks to put the least amount of equity into an investment property, which can include taking out other forms of debt or 3rd party equity.
The danger for the investor when adding more leverage to the property is if the market or property performance deteriorates. For instance, if the market deteriorates and the property is worth less than the purchase price, the investor may not recoup his original equity investment. In this case, though, the equity is not lost until the property is sold.
The biggest risk an investor faces as leverage increases is if the performance of the property deteriorates. More debt translates into higher loan payments and thus the investor has a small margin for error. Should the net operating income at the property fall below the loan payments then the investor either must pay the payments from his personal cash or he faces the risk of foreclosure.
When considering leverage, it is important to fully understand the benefits as well as the risks associated with the leverage being contemplated. When used correctly (which can vary depending on the investment scenario), it is a powerful tool to increase the investment returns. Used incorrectly, however, the investor faces potential losses that can exceed the original investment.
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Commercial Real Estate Glossary
Residential Real Estate Glossary