5th Dimension: Leverage

By: Mark Frentz
www.akerahomes.com
mfrentz@akerahomes.com

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A quick definition

The first image that comes to my mind when I think of leverage is a picture of using a crowbar to pry a nail out of some flooring. I don't know why this is what comes to mind, but it is great example of one type of leverage. With the use of a tool like a crowbar I am able to do very difficult things without very much effort. To pull a nail out of a floorboard is extremely difficult with my bare hands or finger nails, yet with a crowbar I don't break a sweat, I use about 5 seconds of time if the crowbar is handy, and I do no damage to my body or the crowbar itself. A simplified definition of leverage is: The use of a tool to maximize the assets available to you. In the case of the crowbar I am maximizing my strength and understanding of leverage (2 assets) through the use of a crowbar (tool) in order to get a lot done with very little expenditure. 

How does this apply to real estate?

Real estate is THE investment that makes best use of monetary leverage. The only other investment class I can readily think of with leverage of any real kind is the stock market, but only when investing with calls and puts (options) and the greatest leverage potential I can think of with these is about 3:1. Also, as leverage is more used in stocks (ie.futures or even options) the risk factor tends to skyrocket. When I was learning about futures the mentor teaching me said the rule of thumb is... IF you haven't lost EVERYTHING you have invested after about 6 months you may have a chance of doing alright in the future's market. 

Compare what I just stated with real estate. First, you can quite easily make you first investment using 20:1 leveraging, but even after this first investment you can fairly easily receive 5:1 leveraging. Secondly, the risk does not need to increase with increased leverage. Real estate covers its own risk in many ways if it is done properly (as discussed in previous blogs... I will cover this more fully in a future blog). Thirdly, when investing in stocks, you are paying everything off with your own money when all is said and done. If you make money, you can pay off debt with your earnings and if you lose money you need to come up with more of your money yourself. With real estate your debt is paid off by others. That original investment is, typically, the only money you need to put into the property if you have done your proper due diligence because the tenants will not pay off all taxes, insurance, financing (mortgage), management costs, and even future vacancies and maintenance expenses (like your roof, furnace, and hot water tank replacement). This is why I refer to real estate as 'magical'; it far outpaces other investments when all considerations are taken into account. 

Ok, I just used a lot of jargon so I'll make it a little simpler for those who are new to investing and/or investing in real estate. Many people don't have enough money buy a house to rent out. For a smaller starter single detached house in Calgary you need to come up with around $250,000 at the time of writing. The way you leverage the money you do have is by asking a lender (banks as well as other companies... there are about 25 lenders in Alberta) to come up with most of the money. If you don't yet own a house or want to move into another house (that you can rent to others in the future) you can borrow 95% of the money needed for the purchase! That's crazy! For that $250,000 rental property, if you want to just make a start in real estate and are willing to live in it for a year or two, you only need to come up with $12,500! Now, if you are living in the house you will be paying off the mortgage yourself, which is a potential hurdle. Even this can be changed, however, if you are also willing to buy a house with a suite and rent out the basement to someone else (who will give enough in rent to take out your monthly mortgage payments). If you don't want to make the inconvenient sacrifice of moving into a 'future rental property', you can still borrow 80% of the money needed for the property. In the example above you would only need $50,000 to purchase the $250,000 house. Then the tenants will make all the rest of the payments for you (Please recognize I am making simplified statements to make my point). 

What is one of the perceived advantages the stock market has over real estate? That you need less money to get into a deal. This is mostly true. Yes, you can get into stock investing for less than $10, but remember you will need to pay fees every time you sell or purchase more stock (often the cost of even one trade can be around $15, but easily higher). If you don't have the $50,000 needed for a rental, you can always invest what money you do have with a professional real estate investor. I will cover this topic more fully in a future blog, but be extremely careful before you invest your money with someone else. Nobody cares about your money and its growth as much as you do. The three dangers with investing your money with someone else are: 1. They could be a crook and steal some or all of your money, 2. The could be a fool and simply not invest your money well, or 3. Even if they are honest and competent, they will be making money by investing your money (same as mutual funds or most people you go to invest your money in stock markets) which means you won't be making as much return. The best option for making an incredible return on your investment is always to control everything and manage everything yourself. The best option when you don't have the time, energy, understanding to do everything yourself is to make sure you have someone who is honest and competent. The beauty is that there is so much money in real estate that you can find a trustworthy person to do all the work and still make much more than other 'safe' investments (no investment is 100% safe; each carries some kind of risk). 

A summary

Basically what I am saying is that you can use a small amount of money to make a large purchase in real estate. This is called leveraging your money. If you do it properly, you will not be taking on a lot of extra risk and the return on your investment will go way, way up. I'll give a final, quick example: If you use cash to purchase a property worth $250,000 and the property appreciates in value by 5%/year (the Canadian average), you will make 5% on your investment plus the cash on cash return from rent (in that property you make another $10,000, a conservative number after expenses, each year which would give you a total of around 9% total return on your investment). With the same house, if you used $50,000 of your own cash and borrowed the other $200,000, the house would still appreciate at 5%, but that $12,500 will give you a bigger return on your money because you put less money into the deal. Yes, the house appreciated at 5% in both cases, but in the second case you would be making a 25% return on your invested money. There are two other advantages... you are still making money from rent (not as much now because you have a mortgage payment each month), but part of the money you are paying toward the mortgage debt will be put back in your property (the principle payment) which will be, on average over the course of the mortgage, about $7,200. In total, if you are using the bank's money to help purchase your rental property, you will be making almost 40% return on your money, on average, year after year after year! I haven't even included other ways you make money with this type of investment. If you read my last blog in this series, you know you can also be paying less in taxes, which is similar to paying yourself more money each year. At the end of this series on the multitude of ways to make money in a normal real estate deal I will break down a typical deal and how much you tend to actually make on your original investment. I'm convinced it will blow your mind.

Are you beginning to see that very high rates of return in real estate are possible if you do everything yourself, without taking on very much risk? If you went to your financial planner and told them you wanted a 40% rate of return on an investment that also gave you tax breaks they might first laugh or choke on their saliva for a few minutes and then inform you that you would need to take on extreme amounts of risk in order to make that kind of return. With real estate these numbers are not fantastic... they are average. The ways you can make money in real estate are so varied and great that you can hire someone to do all of this for you and even after they are paid well for their services, they can still offer you a really good return on your money. 

If you would like to learn more about investing in real estate please contact me at the email address listed at the beginning of this article or go to my website at: www.akerahomes.com/investing-in-real-estate.html