Investing 101, Using Leverage in Real Estate

Because the market is on the rebound as I write this, I wanted to say a few words about “leverage” in real estate. In a nutshell, leverage is using other people's money to buy property, and why using leverage in real estate can generate significant returns, with only a modicum of risk.

Maybe you recall what a lever is from grammar school math class. It's been a long time since I sat in Miss Alberta’s class in Ridgewood, NJ, but still, when I think of a lever I visualize a worker moving a huge rock using a long pole and wedging that pole against a fulcrum so he can make the big rock move. If you remember that scenario, the key is the length of the pole. I think it was Archimedes who said, “with a long enough pole, I could move the earth.” In real estate, the key is a low mortgage rate.

So how does elementary math and the concept of leverage translate to real estate? Well, let's say you have $100,000 in cash and you decide to invest in a house that costs $100,000. After 5 years passes, you sell the house for $125,000. In this very simple example (no fix-up, no taxes or carrying costs) you have made $5,000 per year, and invested $100,000. Congratulations, you made 5% on your money. It's a better return than a savings account, (but comes with more risk).

OK, now suppose you bought that same house for $100,000, but you only had half of the money it would cost to buy the home. You put down $50,000 and borrowed $50,000. Now at the end of those same five years, when you sell the house for $125,000, and pay the loan off, you will have your $50,000 back and the difference of $25,000 as earnings. That's still $5,000 a year, but you only needed $50,000 to make it happen, so your return on investment (ROI) is 10% a year. (A much better return than a savings account, but again, this example leaves out the expenses of operating the property and servicing the loan.)

Now in a more real world example. You buy the house for $100,000, and apply for a simple mortgage. The mortgage company's loan to value (LTV) is 80%, meaning you can get the money to buy the house with only 20% down. Now at the end of your five year ownership, when you sell the property for $125,000, you have “made” $25,000 on an investment of $20,000. That's $5,000 per year on $20,000 invested, or 25% per year on your money. (Can you do this? Yes, it happens everyday in every state in America).

What if the Federal Government wanted you to make a buck? Consider this, the HomePath program offered by Fannie Mae offers foreclosed homes directly to qualified buyers. This special program allows you to qualify with only 3% down payment and can even give you up to $35,000 back to fix up your home. And better yet, it can be an investment property—as opposed to many federal programs which only are available if you live in the home. I won't kid you, you need a good credit score to get the 3% loan, but if you qualify, it's a great program.

Using the HomePath program, if you buy the home for $100,000, using your 3% and Fannie Mae's 97%, and you sell in 5 years for $125,000. You will realize the $25,000 gain having “risked or invested” only $3,000 of your own money. Now your ROI is 166% per year. In truth, it's not going to be that high because you'll have taxes, insurance, principle and interest to pay each year, but you can see what leverage can do.

And since you only used $3,000 of your $100,000 to make this investment, you have $97,000 still to invest. I would suggest you consider owning more than one house at a time.

Are there risks? Yes, but an investor, who manages his properties will not allow risks to get out of control. He will not allow the properties to deteriorate, and will buy and sell without emotion. Not every property will be a “home run”, but enough will be so that a simple portfolio of 4 or 5 houses, or multifamily homes will produce a good rental income year in and year out, and go a long way to augmenting a retirement plan. And in all my examples, the risk is the same, just the return changes—so the smart investor, (1) buys with as little of his own money as possible, and (2) spreads the risk over multiple properties.

Years ago, on late night TV, there were hucksters flacking “no money down real estate programs” where average folks became very rich, seemingly overnight. Nerds had huge boats, Rolex watches and beautiful girlfriends. That doesn't happen very often. If you're honest, don't plan to get rich quick. But you can get rich slowly. I see it everyday.

Dane Hahn is a real estate professional practicing in Florida and New Hampshire. You can reach him at 941-681-0312 or at dane.hahn@gmail.com. See him on the web at www.danesellsflorida.com.