LEVERAGE AND REAL ESTATE INVESTING

A lever is a device supported by a fulcrum that can be used to lift heavy objects. Archimedes, a traditional Greek mathematician and physicist, determined the law of the lever. He is reported to have said that if he had a lever long enough and a fulcrum large sufficient, he could lift the world. When applied to real estate, the principle of leverage enables investors to purchase properties they would otherwise not be capable of purchasing. Applying the law of leverage to the various financing mechanisms which are accessible could possibly permit individuals to greatly magnify the return on their investments. In fact, without leverage, many people would not even have the ability to purchase real estate because they are able to barely save sufficient money to make even a little down payment.

Investors use the law of leverage to help them lever up the returns on their holdings. The application of this law suggests that investors will use a lever to lift some thing that they would otherwise not have the ability to lift. The lever is supported by a fulcrum, which is defined as the support on which the lever turns. In the case of real estate, the fulcrum represents the use of other people’s money, commonly referred to as the OPM principle. On one end of the lever is an investor’s initial capital outlay, however little it might be, and on the other end of the lever is the real estate being levered. The fulcrum enables investors to apply the law of leverage.

The law of leverage as it applies to real estate rests on the premise that the price of other people’s money must be much less than the return on the asset becoming invested in. For example, if an investor borrows funds from a financial institution within the form of debt, the cost of that debt should be much less than the expected return on the assets it is invested in. If it is not, then it makes no sense to gain access to those funds, simply because the investor will shed money.

Let’s look at a simple example. If the interest rate on a loan is 6.0 percent and also the expected return on assets (ROA) is 10 percent, then the leverage is stated to be positive and would represent a viable investment opportunity. On the other hand, if the price of funds is 8.5 percent and the expected ROA is 5.75 percent, the leverage is said to be negative and would not represent a viable investment opportunity. The difference between the price of funds and also the ROA is referred to as the spread. One of the most common mistakes novice investors make is based on the false assumption that any property bought with nothing down must be a good investment since they didn’t have to put any money down. What they fail to realize, nevertheless, is that if the property has a negative spread and a negative monthly cash flow simply because it is extremely leveraged, the investment won't generate a positive return. On the contrary, it will generate a negative return requiring monthly cash injections that can literally destroy investors if they have no reserves.