Why Is Leverage So Powerful?
Leverage: Purchasing an investment property using borrowed funds.
Borrowing to acquire property makes your money work harder for you! Consider the advantages and disadvantages:
When the value of your property goes up, you don't have to share that appreciation with the bank proportionate to what you invested - you keep 100% of the increase in value.
If you paid 25% down for your property, then your gains are 4X greater than an unlevered investment when the value increases!
Suppose you purchased a property with a purchase price of $100,000 for 25% down. Let's say the value of the property increased by 4% in the first year to $104,000. Your return on investment is 16% in just one year! ($4,000 gain / $25,000 invested). Without leverage, your return after the first year is just 4%.
Leverage allows you to diversify your money across multiple investments - and of course diversification in your portfolio leads to better overall portfolio performance and decreased risk.
This time, let's suppose you have $100,000 cash to invest.
(a) Buy one property worth $100,000.
(b) Buy four properties worth $100,000 each, paying 25% down. You now have a portfolio of properties worth $400,000 and your wealth is growing at an accelerated pace.
Having a diversified real estate portfolio is advantageous for many other reasons:
If one property goes vacant, your other properties are hopefully still collecting rent.
If one property has a big repair expense, you may be able cover the cost with cash flows from the other properties.
Some locations will prove to be more profitable than others. By diversifying, you've increased your chances of having excellent profitability in your overall portfolio.
Some locations are great for cash flow, but expect little appreciation. Others experience amazing appreciation, yet very little cash flow. Combining these investment types into your portfolio allows you to take advantage of both!
If you only pay 25% of the purchase price to buy a property, you can still use 100% of the value of the building to depreciate. This can add up to big tax savings!
There is a downside. Your cash flow each month will be much lower than an unlevered investment because a good portion of your revenue goes to the debt service payment. However, by purchasing multiple properties, your cash flow from the whole portfolio is likely to be greater than just one unlevered property.
Additionally, you are more exposed to market risk when utilizing leverage. There is always a possibility that property values could go down. Ideally, you would be in a position where you could continue to hold the property until values have increased, or that your loan balance is low enough for you to sell and still make a profit.