Real Estate Investing: Positive Leverage.
January 26, 2009
Positive leverage is just that, positive growth of your investment despite o because of financing.
Positive leverage: use of borrowed funds that increases the return on an investment.
Leverage
is like ice cream. It's good until your mouth freezes and you can't
sense the taste anymore at which point it's just a filler. Leverage is
in part what gives real estate such wealth building potential. You put
in only a portion into the investment which grows on the entire value,
but leverage can be negative as well.
Why would anyone go for negative leverage? This was done by tens of
thousands of people for speculative reasons, it was a bet that what
you're losing on the property from negative leverage will be made up by
asset appreciation. In a steadily growing market this works because
the value of the appreciation makes up for the losses due the larger
outflow then inflow, but the risk is simply too high if you mistime the
buy and sell cycle: if you don't have appreciation you essentially have
an money loosing business because the cost of financing soaks up any
cash flow. If you the cap rate is 4.75 and you cost of financing is 6% your losing money unless you have appreciation.
Positive leverage is almost immune to fluctuation in real estate prices if your investment is long term and your goal is cash-flow rather then appreciation.
Here
is what it looks like. If your net return on the investment exceeds
the total cost of leveraging: interest and expenses, then you have
positive leverage: borrowed funds need to return a positive number:
calculating in risk and possibly opportunity costs -of financing- if you want get more detailed.
Borrow the funds at 6% and the return on the cash flow investing is
7.5% then you have a 1.5% spread. That is a very simple view of
things. You cost of leveraging and your return can change depending on
tax consequences so really it's the after tax numbers that really count because those are moneys that stay with you: pocket money.
The next question is, is it enough, is the return good enough versus other investments,
real estate or not: that's why some calculate in opportunity costs to
determine if and how much to leverage. We'll take this on in another
article.
