Feature
by Arthur Griffith
Leverage in real-estate investing is one of the most often used, yet least understood concepts around. With interest rates at historic lows over the past 24 months, many investors have been refinancing, trading up or otherwise re-evaluating their portfolios. Most analysts expect rates to rise this year, making now the perfect time for a refresher.
Most investors will encounter leverage in either of two scenarios: first, in the properties they already own; and second, in those they are considering acquiring. Each situation presents different challenges. But first a quick review of what leverage is all about.
Simply stated, leverage is the use of borrowed funds to increase buying power. The most common example in real-estate investing is a mortgage. Investors use a small percentage of cash as a down payment and finance the rest through a lender. As long as the interest rate at which they borrow is less than the rate of return on the investment, there is positive leverage. When the interest rate is more than the rate of return, there is negative leverage. There are numerous terms used to describe each: positive leverage is also known as cash-flowing, and negative leverage is often referred to as being underwater. Regardless of the verbiage, the concept remains the same. If more cash comes out than goes in, it’s positive leverage. If not, it’s negative.
Already Owned Properties
Many San Francisco properties are owned all cash, no debt. Owners have usually held the property for a long period of time, and the cash flow has paid off the mortgage. Having 100% ownership is the least risky, but for most investors, probably not the best investment strategy.
All but the most conservative of investors should be using some form of debt. Here’s why. Leverage allows for a more balanced portfolio by permitting owners to spread their equity across multiple investments. If an investor owns one or a few properties, all with cash, there is very little diversification. Savvy investors do not keep all their eggs in one basket.
Let’s say an investor owns an apartment property that produces $100,000 a year in appreciation and income. This property was recently valued at $2.5 million dollars and is owned all in cash. In other words, $2.5 million in equity is making the investor $100,000 a year. The rate of return on this investment is 4% a year.
Consider an alternate scenario. If an owner pulled 50% of the equity out of the first property and purchased an additional $2.5 million dollar property, the owner would have roughly the same net income, double the appreciation and also likely enjoy a host of tax benefits in the form of depreciation and interest write off. For more information on potential tax benefits, contact a tax professional.
Purchased Properties
Investors often struggle with how much down payment to use. The ratio of debt to equity is commonly referred to as the loan-to-value ratio (LTV). Each individual investor uses different LTV ratios according to each one’s specific goals. The break-even point is the ratio at which the investment’s income and expenses are equal. More experienced and confident investors tend to finance purchases at or just above the break-even point. Utilizing more debt decreases the required equity investment and increases the return.
For example, an investor buys an apartment building for $1,000,000, putting $100,000 down and borrowing the additional $900,000. In year one, this investment produces $100,000 in income and appreciation. In technical terms, the cash-on-cash return is 100% ($100,000/$100,000). Simply put, the $100,000 initial investment is making $100,000 in income and appreciation. If the investor had made the same purchase without the use of leverage and paid all cash, his return would have been 10%. ($1,000,000/$100,000).
Putting Leverage to Work
Be careful not to overextend. As the LTV ratio increases, so does the potential for negative cash flow. Two common mistakes to avoid when using debt are using too much leverage and picking a type of financing that does not meet your investment goals. The optimal LTV should be a function of an investor’s portfolio, goals and risk tolerance.
The bottom line is this: leverage can be an investor’s best friend or worst enemy. Used correctly, it almost always makes sense to incorporate debt into your investment ownership. Understand leverage, use it to your advantage and watch your wealth grow.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or the San Francisco Apartment Magazine. Arthur Griffith is an apartment broker and a state-licensed appraiser with BT Commercial. For a complimentary analysis of your portfolio’s leverage, contact him at 415-677-0451.Copyright © 2005 by the San Francisco Apartment Magazine. All rights reserved.