How Much Leverage Should You Use for Your Real Estate Investments

ETR reader Steve M. recently wrote in to ask the following 2-part question:

“I finished your Main  Street Millionaire real estate program last year, recently purchased the IRA  program, and have gained some great information to put to use.

“I have two questions. First, could you send me a copy of your real estate assessment guide (spreadsheet) that you shared in the Early to Rise MSM DVD? I would appreciate the help.

“Also, I know how you feel about using financial leverage, but I was curious to get your opinion on something. I have enough money to put down on 2 or 3 homes for either flip or rental purposes. Would you recommend using traditional financial institutions for low-rate loans using conventional down payments? Or do you feel it’s better to go for a low down or no down payment and seek creative financing through other entities?”

Steve asks two very good questions, and I’m going to answer them over the course of two ETR messages. First things first: Today, I’ll talk about the real estate spreadsheet from my Main Street Millionaire real estate investment program. It shows you how you can build a lot more wealth more quickly when intelligently maximizing your leverage. But to do that, you have to buy at a good value first.

Here’s the gist of what the spreadsheet shows …

Increase Your Profits 5-Fold

Say you buy a $100k property with all cash. And let’s say your closing costs are $3,000. So your total initial investment is $103,000. We’ll also suppose that after all carrying costs, and an allowance for vacancies and maintenance, it kicks off $750 in cash a month.

Now, let’s look forward…

Let’s suppose you see a 20% gain on the property in two years. We’ll say 10% of that comes from the fact that you bought the property under market value in the first place and 10% comes from a general rise in the market.

At the end of two years, you’re up by $38,000. Of that gain, $20,000 comes from the increase in the value of the property (your equity gain) and $18,000 comes from the net rents you’ve collected.

That’s the situation on a purchase made with 100% cash. In other words, you’re using NO leverage (or borrowed money) at all. Now, let’s compare it with a situation where you use the same $100k as a 10% down payment for 10 properties just like this one.

What happens?

In this case, for each leveraged property, you have some financing charges and mortgage stamps to pay at closing. So, instead of $3,000 in closing costs, we’ll say each of your $100,000 properties is going to require $5,000 in closing costs. But you’re going to borrow that too.

So now, you’re borrowing $95,000 on each $100,000 property. You borrow $90,000 for the mortgage loan and $5,000 to cover the closing costs. Let’s say your interest rate is 6.5%. So the $95,000 you borrow on each property now costs you about $600 a month.

Instead of netting $750 a month on each property, you’re now netting just $150 ($750 minus the $600 loan payment). Then you pay someone $100 a month to manage each property. So, your net income drops to just $50 a month.

We assume, once again, that the value of each of these properties is up 20% after two years (10% because you bought under market value in the first place and 10% from a general rise in the market). What’s your gain now?

Instead of being up $38,000 (as in the zero-leverage example) … you’re now up $234,000!

And the longer you extend this scenario, the bigger your advantage becomes.

How does that happen?

Well, when you use leverage, you cut down on your net income. But you still get ALL the appreciation. And that’s where the big money is.

In this case, your net income is just $600 a year per property. But you were able to buy 10 properties that way. So that’s $6,000 in a year, combined, or $12,000 after two years. You’ve given up $6,000 in net rents, compared to the zero-leverage case. But you more than make up for that in the appreciation.

That’s the real gravy. In the leveraged case, you get 20% appreciation on a million-dollar’s worth of property, instead of 20% on $100,000 worth of property. That means your appreciation is $200,000.

And here’s a little something extra: You get some amortization too. Amortization is the equity you pick up as you steadily pay down a loan. In this case, the amortization would work out to about $2,200 per property after two years … or $22,000 all told.

So your total gains in the leveraged case are $234,000. That’s $12,000 in net rents, $200,000 in appreciation, and $22,000 in amortization.

That’s nearly a $200,000 advantage over the gains of $38,000 in the zero-leverage case!

Does this mean you should just run out and borrow and buy like crazy? ABSOLUTELY NOT! You have to know how to Buy Right first. That’s the key thing that makes this work.

High Yields Permit Maximum Leverage

The yields I used in the above example aren’t the yields most investors are getting – especially in the bubble markets (including mine, in South Florida). But when you know how to buy under market value, you can get them.

For instance, in another state, a partner and I are at contract on a 4-unit property with gross rental value of $2,200 a month, or $26,400 a year. The purchase price is $185,000 and it needs about $10,000 in repairs. At that point, going by comps right on the same street, it will be worth about $215,000 to $220,000 – giving us $20,000 to $25,000 in instant equity.

But the real advantage here is in the cash flow.

We can certainly put 20% down to buy this property. But it produces so much cash that we could borrow the entire $185,000 and the $10,000 for repairs at an average cost of 7%. That would put our monthly loan payments at about $1,300 a month, leaving us with $900 a month. Subtract $400 for taxes and insurance, $150 for professional management, $100 for common-area utilities, and we still build up a $250 monthly cushion toward vacancy and maintenance.

And that’s with 100% financing. So the $47,000 we might have taken out of our pockets for down payment and repairs is still available for other deep-value, cash-flowing-like-a-cash-register investments.

And on this same property, even though it may be breakeven to start, we still get all of the appreciation and amortization … while the property pays for itself (including professional management fees).

Be a Deal Maker – That’s Where the Real Money Is

When you’re a skilled real estate investor, you’re not a property manager or landlord. You’re a deal maker.

Learn how to find the deep-value deals. Use as much leverage as is appropriate to the deal. Line up the best financing and terms. Then let the property pay for itself and manage itself. You’ll get all the upside when you decide to sell … and you’re immediately free to go after your next deal, where the real money is.

If you need income now, you can flip properties for cash. But, as you meet your cash needs, you should take advantage of smart leverage to control as many cash-flowing properties as possible. It all starts with buying right first. Then, go ahead and borrow right.

In my next ETR article, I’ll address the second part of Steve’s question and talk about “creative” financing versus traditional bank financing … and when you should use each.