The Power of Leverage
Leverage in a real estate investment is the use of financing to increase the profitability of an investment. This is accomplished by securing financing when purchasing a property.
It is important to analyze the investment, your vision for the property as well as your goals. Then consider the terms of the financing vehicle prior to making your offer to purchase. Quite often by securing financing an investor is able to increase his or her return on investment while keeping his remaining capital liquid.
This reminds me of a client who desired to purchase a winery I had available for sale for $5 million. His plan was to pay cash for the investment, however I asked that he consider securing financing for the purchase in order to improve his rate of return as well as his after tax position.
I created an analysis showing how over a 10 year holding period, with the down-payment of 35 percent and a commercial loan for 65 percent, will increase his return after taxes from 16 percent to 26 percent. The nuts and bolts of the analysis can be complicated, but it essentially looks at his initial investment of $1.75 million with financing compared to $5 million with no financing and the cash flows produced by the winery operations. Mixed in the analysis is the amortization of the loan, the paying of interest and the tax advantages.
Certain things remain the same whether there is financing in place or not: the revenue generated by the business does not change, nor does the appreciation of the real estate and therefore the value of the investment after 10 years. So, in essence by securing financing my client was able to use $1.75 million of his capital to control a $5 million investment that generated $1.5 million of revenue in the first year.
Plus, he still has $3.25 million of his original capital either working for him in another investment or possibly used to grow his winery operations. What would you consider an advantage, using a smaller amount of capital or a larger amount to make the same revenue and the same appreciation of the investment asset? You greatly increase your return with your lower initial investment. By the way, I forecasted his winery to be valued at $10 million after 10 years.
Financing is a good tool to improve the return on your investment, but it must be used wisely and conservatively. Financing is a strategy - it is different when used for your personal residence.
It is difficult for many to pay all cash for the purchase of a home so financing is often secured. Remember, your personal residence is not an investment or a tax shelter so financing should not be pursued with this in mind. I am conservative when it comes to this, therefore I recommend to my clients and those I can influence to work hard to pay off your home mortgage. The security of owning your home free-and-clear is a powerful thing.
Curious about other aspects of analyzing a real estate investment? Give me a call, send me an email or enter a comment below.