Do You Know How to Handle Leverage?

Every real estate investing guru will tell you to "use other people's money" to make your millions. None of them even mention using other's money to lose millions. Do you know the difference? Do you know how the same collection of "other people's money" can be good or bad?

The issue is LEVERAGE.

What is leverage?

Investorwords.com defines leverage as follows:

The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders' return on their investment and often there are tax advantages associated with borrowing.

John Reed defines leverage as follows: the use of borrowed money to magnify return.

Let me illustrate leverage with stocks and then I will shift back to real estate.

For the average investor in the stock market, there is no use of leverage. If the stock or mutual fund is trading at $100, then you have to have $100 to invest for each share you want to purchase. If you want to buy 100 shares, then you need to come up with $10,000 to invest in that stock or fund (plus any transaction costs).

If that stock gains 10 points and moves to 110 per share, then you gain 10% on your investment or $1000, which would take the portfolio total to $11,000. Alternatively, if the stock loses 10 points and sinks to 90, then you lose 10% or $1000, which takes you down to a new total value of $9000. All of this is pretty straightforward. In this example, I am using no leverage.

How does leverage come into the picture?

Let's suppose that instead of investing $10,000 of my own money I invest $1000 of my own and then borrow the other $9000. How does that change my return?

Should the stock move to 110, then the gain on the total money invested is still 10%, but what is the gain on my money? How much did I invest? $1000 of my money. What is my total gain? The new value is $11,000, so I gained $1000 on my $1000 invested, which is a 100% return. Wow, life is good!

There are two sides to the story.

What happens when the stock goes down? I lose $1000, which means, I have a 100% loss on the money I invested. At the end of the day, if I were to cash out, I would have $9000. I would pay of my loan and then walk away with nothing. My original investment would be gone. Wow, life is not so good. (Of course, there would be transaction costs and interest to pay, but I am keeping things simple for the sake of illustration.)

The average stock market investor does not use leverage or buy on margin.

In real estate, however, the exact opposite is the case. The average investor does not pay all cash; instead, the majority of real estate investments are bought "on margin" or with borrowed money. Leverage is part of the equation.

What people tend to forget is that just like a stock, real estate can go up or down in value. It rarely will go to zero (I could imagine an uninsured building burning down on a piece of property with toxic waste in the ground, then your investment would be worse than a loss of all your money invested; you could be fined or sued for more than your original investment).

The above illustration of the up and down moves of stocks and the positive and negative impact of leverage must be kept front and center in your mind if you are going to invest in real estate. Leverage is both a friend and an enemy. As one author put it: "Borrowed money made nearly every modern real estate millionaire. And borrowed money broke nearly every modern real estate failure."

If you are just getting started in real estate or if you are adding to your portfolio of properties, you must assess your risk at all times. When things are going well, it is easy to look like a genius. Your borrowed money is working to your benefit.

However, things don't always go well. Tenants stop paying, neighborhoods change, real estate values cycle downward, cash flow gets tight, interest rates rise, unexpected repairs pop up. When these things happen, can you still handle the leverage you are using? Do you know how to answer that question? Can you calculate an answer so you know when and at what amount of leverage you would answer "yes" and at what amount of leverage you would say "no"?

Everybody knows that buying stocks on margin is risky, but fewer admit that buying real estate "on margin" is risky. They need to wake up to that reality. You need to wake up to that reality before it's too late.

Doug Peterson

[http://www.lendingdynamics.com]