What is Positive Leverage in Real Estate and How Can it Help Me Increase My Rate of Return?
To understand what positive leverage is, you first need to understand what leverage is.
What is Leverage?
In regards to real estate, leverage basically means debt. Leverage / debt gives the borrower the opportunity to control a much larger investment than they otherwise could if they relied solely on their own capital / cash. Leverage increases the borrowers purchasing power. For example, I can control a million dollar property by only contributing $250,000 in capital and borrowing the remaining $750,000.
What is Positive Leverage in Real Estate?
Positive Leverage occurs when the investment property produces a return GREATER than the cost of borrowing the money (i.e. the interest rate I’m charged to borrow the money). Positive leverage increases the borrowers rate of return.
Said in another way, if the cost of borrowing the money is less than the return provided by the property, then I’ve used my leverage (i.e. debt) to positively increase my rate of return.
Positive Leverage as a Wealth Management Tool:
As the below example will demonstrate, positive leverage, when used correctly, can be one of the most powerful tools you use to build wealth.
Interest rates today are still very low compared to historical standards and as such, provide a lot of opportunities to create positive leverage.
Positive Leverage Example:
I have the opportunity to purchase a Taco Bell for $1,000,000. The capitalization rate is 7.5%. I can either pay cash for the property or I can borrow 70% with the loan cost being a 5% interest rate. What does this look like?
As the above example shows, the property produces a 7.5% return and if the borrower pays “all cash” for the property the final return is 7.5%. However, because the borrower is only charged 5% on the debt amount, if the borrower instead uses leverage (i.e. debt), their rate of return increases from 7.5% (all-cash) to 13.3% (leveraged). This amounts to a 77% greater return than the borrower would have otherwise received. Where else can you obtain a 77% return?!?!?
Of course, the above example is an overly simplified calculation of these two options. In reality, the loan will most likely involve principal and interest payments and the internal rate of return (IRR) calculation would be a better method for calculating the actual return on the investment, but it makes the point about what positive leverage is and how it can significantly help you increase your rate of return on investment real estate.
Does this mean I should always use debt when purchasing investment real estate?
Check in again next week when we discuss this topic further.
For additional information about financing real estate investments, see the NNN Resource Center.