First, what is leverage in real estate investment? Here’s one definition that suits our needs: “A method of financing an investment by which an investor pays only a small percentage of the purchase price in cash, with the balance supplemented by borrowed funds, in order to generate a greater rate of return than would be produced by paying primarily cash for the investment; the economic benefit gained by such financing.”
Leverage doesn’t stand alone as a financial decision, as it involves some elements of risk. The more leverage you use, the greater your risk might be. A very low down payment might produce a great return on your cash invested, but a reduction in the amount of rent you can charge could take you into a negative cash flow situation with the higher mortgage payment.
However, a careful consideration of the risks balanced with the selection of favorable financing terms, can produce excellent returns for the real estate investor. Let’s look at an example of leverage that looks for the return on investment as an annual percentage of the actual cash invested at purchase:
· Purchase price of a duplex rental property of $250,000
· Financing at 7.5% interest for 30 years
· $3300 annual expenses for taxes, insurance and repairs
· Rental of $1100/month for each of the two units
Let’s look now at the ROI (Return on Cash Invested) with different cash up front down payments:
$250,000 paid in full in cash:
· $26,400 in rents – $3300 expense = $23,100
· $23,100 / $250,000 = 9.2% ROI
50% or $125,000 down payment:
· $10,488 in mortgage payments + $3300 expense = $13,788 cash out
· $26,400 in rents – $13,788 = $12,612 Net Operating Income
· $12,612 / $125,000 cash in front = 10.1% ROI
10% or $25,000 cash down payment:
· $18,879 in mortgage payments + $3300 expense = $22,179 cash out
· $26,400 in rents – $22,179 = $4221 Net Operating Income
· $4221 / $25,000 cash in front = 16.9% ROI
There is room in between, with a 20% down payment yielding approximately 12.6%. You can see that our return on cash invested can increase significantly with lower down payments. However, less cash down payments mean higher monthly mortgage payments. So, should rents in the area suffer a downtrend, you could have a problem, or even negative cash flow.
Another potential risk would be adjustable or other short term mortgages that could result in interest rate increases. The prudent investor will take these risks into consideration before making highly leveraged purchases.