Real Estate Investing Primer on Leverage
I received a call yesterday from Victor, an investor that was interested in buying a condo here in South West Florida. We talked about Grand Isle, Oasis, Brixton’s other projects, and real estate investing in general. (www.brixtondevelopment.com)Then we got to the topic of leverage. I told Victor that that the real estate properties he can buy with 10% leverage are better than deals he has to put more cash into.
I realize that most of us think we know what leverage is. What I would like to do, however, is get pretty basic and review for you what leverage can do for you in real estate. This kind of leverage is almost impossible to get in other investments.
In mechanics, a lever is a device that will enable you to move a big weight with a very small weight. Leverage in real estate enables you to control an expensive piece of property with a small amount of cash.
First, let examine a property you buy with no leverage. Let’s assume you buy a $100,000. condo. For simplicity sakes, let us also assume that there were no other costs in acquiring the property. Our third assumption is that the property increases 10% per year in value (appreciation). You buy the property on January 1 by investing $100,000. On December 31 the condo is worth $110,000. Your investment has earned you 10%. If we are able to rent that property for $1000 per month, and we assume expenses of $167/month, we have additional income of $10,000. Now our investment earned a total of $20,000. For example:
Annual appreciation $10,000
Gross income: 12 months x $1000= $12,000
Expenses -2000
Our net benefit $20,000
Without looking at any tax advantages we have earned $20,000 ($10,000 appreciation and $10,000 income) or 20% on our $100,000. This is pretty good!
Now let’s see how leverage works. Instead of paying cash for the $100,000 property let’s put up $20,000 and borrow the rest.
Annual appreciation $10,000
Gross income: 12 months x $1000 $12,000
Expenses w/o interest -2,000
Interest expense for $80,000, 7% loan
for 12 months is -5,574.
Our net benefit $14,426
In the leveraged example we earned $14,426 on our $20,000 investment. This is a return of 72%. This is what leverage is all about. Now keep in mind we have not even considered that you are paying the mortgage down ($813 the first year) or the depreciation that you can write off ($2909 the first year).
The reason I mention this type of leverage is that you can now buy a condo in WCI’s Grand Isle and CONTROL that condo for only ten percent for up to 1 ½ years. In The Colony you can do it for 20 to 30%. If the condo appreciates 10% a year, and you have no expenses (you will not – they are not built yet) you 10% will be worth , on paper, more than double what you put in.
If you have cash to use that is a great article....If I had loads of cash...i would go to the convential investor .com
Good article GFous!
Your comment makes we want to have a discussion of what a creative investor is.. To me the conventional investor does not do leveraged real estate.
Gregg,
I didn't mean it as an attacking comment. I learned how to leverage from your article. My point was that I personally didn't have the $100,000 anyways, so I would have to be creative and leverage.
Brandon