For hardcore Dave Ramsey fans out there, they know that he suggests paying cash for everything. Including real estate investments. He is wrong. I like Dave and originally followed most of his rules when I was starting out in my money journey. However, the further down the path I got and the more educated I became, I realized he is wrong about buying investment real estate without leverage. Dead wrong. Here’s why.
First off, the majority of individuals are not able to buy a property outright with 100% cash. With the average cost of a home in US being around $200,000, that would take most Americans almost a lifetime to save for (another reason why you need to focus on increasing your income but that is for another post). Even if you are flush with cash I still wouldn’t recommend you dumping it all on one property and paying cash.
Leverage, AKA debt, “is an investment strategy of using borrowed money- specifically, the use of various financial instruments or borrowed capital- to increase the potential return of an investment.” This is business debt used wisely to increase your wealth. This is not stupid consumer debt where you are buying a new car, tv, or furniture (Dave and I are in full agreement here). With that being said, let’s examine two different scenarios, One in which 100% equity is used to fund the deal and one in which leverage is deployed. These examples will demonstrate the effects of leverage on an investors ROE (Return on Equity).
Let’s suppose an investor is looking to purchase an income producing property. For the sake of this example, our investor will be purchasing a single-family home. The home is a 2,500 square foot, 3 bed 2 bath located in a popular suburb of Tampa, Florida. The home is listed on the market for $300,000 and we will assume that this will be the purchase price. The investor’s primary concern is to maximize his/her return on their investment. We will assume perfect capital markets, meaning we will not consider market frictions such as taxes in our calculations.
Example 1: 100% Equity:
In this first example, our investor decided to park 100% of his/her available capital into this one property. This means that on a $300,000 investment, our investor will receive an internal rate of return of 13.5% over the course of a 10-year holding period. The IRR is a fancy way to look at and compare the overall returns of an investment. It takes into consideration time, cash on cash, capital gains, and other payments you receive over the lifetime of ownership.
From a risk perspective, our investor is 100% exposed, meaning any losses on the property come out of the investor’s pocket. Let’s see what effect leverage has on our investor’s ROI in this next example.
Example 2: Loan To Value (LTV)= 70%
In this example our investor has decided to use some leverage. The bank offered a 70% LTV ratio, meaning they will cover 70% of the purchase price and our investor will be responsible for 30%. Our investor is now only putting in $90,000, as opposed to $300,000. You might notice that the monthly cash flows in example 1 are greater, but remember that the investor in example 1 has $300,000 of his/her own money in the deal. You can see by the above calculations that the investor’s IRR is now 23.78% in comparison to 13.5%.
Not only does the investor in example 2 earn a higher IRR, he/she can take the remaining capital that was not invested in the deal and duplicate what was done in example 2 on another two properties and still have some cash on hand!
The bottom line is your money works harder for you when you use leverage. Nearly twice as hard in our above example. If you have many wealth building years left in your life this can make a dramatic difference in where you end up. Again, this is smart debt used to make you more money. This is not bad debt that is going to cost you every month on things that are going down in value. Understand the power of leverage in real estate and use it to create financial freedom in your life.
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