Leverage Is the Key to Enhanced Investment Returns
Leverage is using borrowed capital (other people’s money) to increase the return on an investment. Leverage can significantly enhance your return on investment. With interest rates at all-time lows, it’s easy to use leverage to improve your returns.
Here’s how it works. Assume you have $100,000 you want to invest. If you invest it in an income-producing rental property, you can buy a $400,000 asset. You put up $100,000 of your own money and the bank lends you another $300,000 at a fixed interest rate amortized over 25 or 30 years. If the interest rate on your mortgage is lower than the overall return on the property without a mortgage, you have positive leverage.
For example, say your $400,000 property generates a net cash flow of $32,000 each year without any debt financing on the project. That’s an 8 percent cash-on-cash return on your investment ($32,000 / $400,000 = .08 or 8.0 percent).
Now say you invest your $100,000 and borrow $300,000 at 4 percent interest, amortized over 30 years. The monthly mortgage payment is $1,432 per month or $17,187 per year. Deducting the annual mortgage payment from the net cash flow of $32,000 gives you $14,813. That increases your return from 8.0 percent to 14.8 percent ($14,813 / $100,000 = .1481 or 14.81 percent).
By using leverage your annual cash-on-cash return increased by 85 percent (.1481 – .08 = .0681 / .08 = .8513 or 85.13 percent). That’s incredible! Why is it possible to generate higher returns by borrowing money? It’s because banks consider real estate a good risk. They’re willing to lend you money at rates that are below the actual return you can achieve on the property without having any debt.
When buying income-producing real estate, positive leverage is the key to enhanced investment returns.
ABOUT THE AUTHOR
Ken has been in the real estate business for over 40 years and has personally overseen the development and management of over $350 million worth of assets. Ken holds a B.S. degree in Accounting from Brigham Young University, a MBA from the University of Utah. Licensed real estate broker since 1976. He holds the following designations: CCIM, CPM, CRS,CCA. Served as the president of the Utah Apartment Association.