Principle of Leverage In Financing Mechanism
Posted under: A lever is a tool supported by a fulcrum that can be used to lift heavy objects. Archimedes, an ancient Greek mathematician and physicist, calculated the law of the lever. He is reported to have said that if he had a lever long enough and a fulcrum large enough, 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 that are available can potentially allow individuals to greatly magnify the return on their investments. In fact, without leverage, many people would not even be able to purchase real estate since they can barely save enough money to make even a small 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 something that they would otherwise not be able 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 small it may 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 cost of other people’s money must be less than the return on the asset being invested in. For example, if an investor borrows funds from a financial institution in the form of debt, the cost of that debt must be less than the expected return on the assets it is invested in.If it is not, then it makes no sense to borrow those funds,because the investor will lose money.
Let’s look at a simple example.If the interest rate on a loan is 6.0 percent and the expected return on assets (ROA) is 10 percent, then the leverage is said to be positive and would represent a viable investment opportunity.On the other hand, if the cost 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 cost of funds and 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 purchased with nothing down must be a good investment since they didn’t have to put any money down.What they fail to realize, however, is that if the property has a negative spread and a neg- ative monthly cash flow because it is highly leveraged, the investment will not 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.
Take a moment to review Table5.1. It illustrates the effect of price appreciation using no leverage and an initial investment of $500,000, which represents 100 percent of the purchase price. The table applies 5, 10, and 20 percent growth rates over a period of 25 years. An investor in this scenario using an annual growth rate of 5 percent will enjoy a total return of 238.6 percent over the 25-year period. Not bad.
Now let’s compare the returns in Table5.1 to those in Table5.2, which illustrates the effect of price appreciation on leverage using an initial investment of $75,000, or 15 percent of the purchase price. This table also applies 5, 10, and 20 percent growth rates over a period of 25 years. An investor in this scenario using an annual growth rate of 5 percent will enjoy a total return of a remarkable 1,590.9 percent over the same 25-year period! The use of leverage has allowed the investor in the second scenario to enjoy a return almost seven times greater than the investor in the first scenario.
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My name is Jon Monroe and I have been an investor in rental properties since I was 27. With my many years of experience I have decided to create this website to help share the knowledge I have gained.