September 13, 2019
Let’s not kid ourselves. There actually may be downward price pressure on interest rates right now. Or, at least, we’re not overly concerned about an interest rate hike in the offing. So, is now maybe a good time to either borrow or refinance? Perhaps. But wait a minute! Didn’t you just spend the last five years paying down student debt or—worse yet—credit card debt? Wasn’t it borrowing that got you into that mess? Maybe so. But systematically employing leverage, once you’ve built a solid financial base, is something altogether different.
Leverage is one of those financial words that is familiar but rarely defined. We’ll get to the definition in a moment. But first, think about turning a nut around the end of a bolt with a wrench. When you use the wrench, you don’t grab the wrench up higher near the nut. Instead, you grab the wrench along the handle, because doing so makes the job easier. This analogy describes one key advantage of leverage: the ability to enter the investment with less financial strain. Now, think about driving a car. The harder you press on the accelerator, the faster the car goes. This fact is akin to another benefit of leverage: the more leverage you employ in an investment, the higher the potential return on investment can be. Enough stories…let’s define this thing.
Simply put, leverage is using borrowed capital (debt) to potentially increase the return on your investment.
Leverage is exploiting an opportunity for your own advantage. In the financial world, leverage means borrowing money in order to buy something. Most likely, you used leverage to buy your first house. That leverage was in the form of a mortgage. If your first house cost $250,000, and you had to wait until you had all $250,000 saved up to buy that house, chances are you’d still be living in your parents’ basement. That’s the beauty of leverage. Depending on the particulars, you can come up with only a fraction of that $250,000 and, with good credit, qualify for a mortgage to buy that house, and enjoy the benefits of homeownership now rather than later—or never.
Hanna started investing in single-family rental homes in her late twenties and, over the years, has graduated to owning two or three small name-brand hotels and a couple of retail strip centers. She recently accepted an offer to sell one of her hotels for $500,000 and now has decided to buy a large retail center worth $1.5 million—larger than any property that she currently owns. Enter leverage. Even though Hanna will be flush with cash after she sells the hotel, she’ll need even more cash to buy the large retail center. To accomplish her objective, she uses a portion of her sale proceeds as a 25% down-payment on a commercial mortgage. The numbers look like this:
Without leverage, Hannah may not be able to buy the large retail center. However, with leverage, not only is she in a position to purchase the large retail center but she also is able to retain $125,000 to invest in the property as cash reserves to operate and manage the center. This point underlines yet another advantage of leverage: the ability to enter an investment while preserving your cash position.
Ah . . . yes. There always is. First of all, leverage generally involves borrowing. As such, you’ve created another line item of cash outflow—namely, debt service—which is the monthly payment that you make to the lender for the mortgage. If the investment generates enough cash flow to far outweigh the debt service, then perhaps you proceed and use leverage. However, if the net cash flow of the investment after debt service is hardly negligible, then perhaps you re-think making the investment. Second, the more leverage you’ve employed for an investment, the worse your returns can be, if things go wrong. This point is key and why it pays to enter an investment conservatively, with money that you’ve earmarked for investment after your home budget is balanced. Third, there is a type of leverage that doesn’t involve debt. Instead, you take on an equity partner. This idea sounds good, at first, because you’re eliminating debt service. However, you’re also watering down your ownership in the investment. In our example above, instead of Hanna owning 100% of the new retail center, she may wind up owning less than 50% of the property with a partner.
We’ve all heard of Warren Buffet’s story—that he made most of his substantial fortune after the age of 50. We also may have heard that Colonel Sanders didn’t open his first Kentucky Fried Chicken location until after the age of 60. Add to those stories that of Hanna from this article. Hanna’s story is based on an actual borrower—with a different name—who is currently using leverage to further her investment interests. Whether we’re talking about a billionaire like Warren Buffet, a late-bloomer like Colonel Sanders, or a rising star like Hanna, the use of leverage, to a varying degree, is a common theme.
How will your story end?