Go the first post in the 5 ways to make money with investment properties series.
Benefits and dangers of leverage with investment properties.
Whenever people get talking too much about O.P.M. (other people’s money) keep your hand on your wallet and start moving towards the door because they’re about to pitch a get rich-quick-scheme to you. On the other hand, leverage is a valid and powerful way to magnify you returns (good or bad) on an investment.
Say you’re opening a store, and you have the money to afford a small 800 sq. ft. shop. In such a space you feel you could earn a 20% annual return on your initial investment, working there full time. If you considered borrowing money at 7%, getting a larger shops (say 2000 sq ft), selling a wider range of merchandise, etc, etc and earn a projected return of 14% on your money invested and the money borrowed. All other things being equal, it would probably be well worth considering borrowing the money. Your time investment (1 year) is the same either way, but a 14% return on your investment, plus a 7% return (14%-7%) on the borrowed capital would give you a higher return if they were equal amounts (21%), and increasingly large returns the more money you borrowed after that.
The obvious downside is the larger venture will have a high risk (volatility). If you start a business with your own money and it goes bust, you lose that money. If you start a business with borrowed money and it goes bust, your creditors will do whatever they can to make your life unpleasant.
With real estate, a commonly used example is buying a house for $100K. If you buy the house outright (with your own money) and it appreciates 3% (so its now worth $103K), you’ve earned a 3% return on investment (ROI). If you buy the house for $100K, with 10% down ($10K), and it appreciates 3% you’ve earned a 30% ROI!
Clearly in such a situation the interest, maintenance and closing costs to buy and sell the property would be far more then 3%. However if you rented the house out to cover all these costs, clearly its nicer to earn $3000 from a $10K investment instead of $100K investment. Even then its not a totally fair comparison, as your costs would have been lower if you hadn’t borrowed the money, so therefore your return would have been higher (more then 3% – probably more like 10% if you had avoided a 7% mortgage). We’ll ignore this for now, although I do acknowledge the omission.
My consideration with leverage is to look at the ROI of the investment, add a margin of error and make sure that I expect to be earning more then I’m paying for using OPM. At 5.05% (what I got on my last mortgage), it isn’t too hard to get better returns then this. I would be very reluctant to borrow money at 20-30% (like you sometimes hear about people doing to pursue “sweet deals”).
One of my favourite lines about leverage is that its a power tool. It lets a craftsman do a much better and faster job, but you can injure yourself more easily and much worse.