USING REAL ESTATE LEVERAGE

One of my clients recently asked me (somewhat sheepishly) to explain real estate leverage. They actually understood the basic concept but not the down side.

Let’s use some SIMPLE (perhaps unrealistic) examples. Your neighbor buys a $100,000 small rental house. The purchase price is all cash—no loan. One year later the neighbor sells the property for $200,000 NET after all expenses. In this absurd example, your neighbor has theoretically made a 100% profit on his investment, i.e. $100,000 profit on $100,000 initial investment.

Now let’s suppose that the neighbor purchased the exact same house at the same purchase price and put $50,000 cash down and borrowed $50,000 as a first trust deed at 8% interest. He again sold it one year later and netted $200,000 from the sale. In this case, the neighbor made $100,000 profit minus the $4,000 interest paid (one year). This profit was $96,000, HOWEVER the actual investment was only $50,000. The neighbor made almost a 200% return on his initial investment in this example, i.e. $96,000 profit on a $50,000 investment. Obviously, by now you see where I am heading.

A more typical scenario would be a 20% down payment with an 80% first trust deed. Let’s assume the 80% first trust deed, i.e. $80,000, was at 8%. The payment was again "interest only." This time, assuming again a $200,000 (net) sale, the neighbor made a profit of $100,000 minus $6,400 interest for the loan ($80,000 times 8%). In this example, the neighbor made (almost) a 500% return on his investment.

Many "gung ho" leverage buyers try to put little or no money down. If we use the same figures with a 10% down payment, the profit would be $100,000 minus $7,200 interest payments and the neighbor would make over 900% profit on the $10,000 investment. Many sophisticated leverage buyers actually purchase property with "zero money down" and the return on investment figures doesn’t even work, as the neighbor in this case would have made $100,000 profit with zero down payment and only $8,000 in mortgage payments during the year, i.e. $100,000 profit on investment but $8,000 in payments.

Many years ago I taught a course in real estate finance at Glendale College. One of my assignments was to make a chart using figures such as those above, but on a two year purchase and resale. Obviously the return was divided by two years rather than the simple one year example above. The chart that my students constructed had every increment from zero down payment through 100% payment in 10% increments, using the example of a $100,000 purchase and $200,000 (net) sale.

Unfortunately, there are two sides to this seemingly rosy picture. Though ownership of real estate should reward you handsomely over time, the above figures are NOT intended to steer one to the conclusion that the BEST way to buy real estate is with little or no money down. Consider the other side of my chart and previous school example. In my second example, a person purchases a property for $100,000 and the market GOES DOWN. Though that seemed impossible during the latter part of the 1970’s and the latter part of the 1980’s, that possibility certainly became apparent in the early 1990’s. In this new example, a job transfer or financial hardship forces your neighbor to sell the $100,000 house for $80,000. Though it is not realistic to assume that real property will depreciate 20% in one year, it is also not realistic to assume my 100% increase in value either. In my new example, a person investing $100,000 cash would have only lost $20,000, or 20% of their investment. A person investing $50,000 cash would have lost 40% of their investment. The typical 20% down buyer ($20,000 down) would now have lost ALL of their investment. Imagine the highly leveraged 10% buyer or zero percent down buyer. If their credit was important and they didn’t wish a foreclosure on their record, they would have to cough up an extra $10,000 to $20,000 just to get out of the deal. Imagine a $20,000 loss on an initial $10,000 investment (200% loss), or a $20,000 loss on no money down.

Hopefully, this article has given you food for thought before you take Saturday morning television infomercials to heart and rush to buy property with "no money down."

Peter Rosenthal
VIP Trust Deed Company