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Question Real Estate Investors Ask Frequently

December 22, 2010 Leave a comment Go to comments

In a post last month, I asked many questions, many of which are taken from conversations I have all the time. It was the first of a two post series, which was published in November, beginning the 17th. Go here to see all the questions in that first effort. There were a lotta bases covered in those two posts.

Today we answer the following question.

You put a 50% down payment on a fourplex which yielded 6% per year while you owned it. The interest rate on your loan was 5.5% fixed. Was that a positive or negative use of leverage?

 

If your answer, right, wrong, or completely off the mark, is based upon the size of the down payment, we need to talk. Though down payments can sometimes make a ginormous difference in return, it’s definitely not the primary factor in the concept of leverage. Uncounted legions have learned the ugly way why 0% down can presage horribly negative leverage, a term I’m sure most hadn’t heard of before. Meanwhile, 50% down payments can sometimes lead to the best leverage ever. It all depends.

Depends on what?

It’s all about the relationship between the cost of borrowed money and the yield generated by the investment on which the borrowed money was secured. (Sprained a pinky typin’ that.) This is pretty much one of those either/or concepts.

Either your investment yields a return higher than the cost of your borrowed money, or it does not. Borrow at a 20% interest rate while enjoying a return of 23%, and you’re much better off than having borrowed at 4% with a yield of 3%.

Not exactly rocket science, eh?

How many people have lost who knows how much investment capital thinking their return would, by definition, be increased depending on how small their down payment was? Gotta admit, it would be pretty dang convenient, wouldn’t it?

Alas, it’s the myth that won’t die.

Positive leverage is created when the yield on your investment is greater than the cost of your borrow money. Negative leverage is, um, the other side of that coin. The coin only has two sides. And yeah, neutral pretty much explains itself. (A mentor once told me, over and over and over again, that repetition was the mother of learning.)

Can the size of the down payment sometimes turn an investment from negative to positive leverage? You betcha. The irony is, that contrary to popular belief, it happens almost always when the down payment is increased, not decreased. The exception to that rule is when you know for sure cash flow ain’t gonna add much if anything to the property’s yield, but you also ‘know’ that there’s gonna be some pretty sexy appreciation. The gain in actual market value will then generate a yield greater than your borrowed money’s interest rate. Most folks call that speculation.

Here’s the bottom line.

As long as your cash flow analysis is objectively realistic, and you can easily discern a higher yield on your investment than you’re paying for the use of the lender’s money, you’re good to go. Try these fun exercises.

Though we insist on operating expenses being boots-on-the-ground reliable, we still, like a recent commenter said, like to divide the gross scheduled income by two to see if there’s still some cash flow. Sure, you know your expenses aren’t that much, but Murphy doesn’t seem to care what you and I know.

I go a step further.

Ask the question: How would this property perform if it was 100% financed? Did this recently with ALL the properties we’ve recommended our clients acquire in the last few years. It was illuminating — and gratifying.

Virtually all of ‘em, if 100% financed with today’s current available interest rate, would break even if the total cost of operation including everything was 45% of the scheduled gross income.

Think about that a minute. No down payment. Vacancy and expenses at more than your boots-on-the-ground due diligence shows. And still, they’d break even with no down.

Works for me.

Just remember, leverage ain’t about down payment. It’s about the relationship between the cost of your borrowed money and the property’s yield. The rest is happy talk.

Reprint from Bawldguy.com

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