If you were to ask a group of people what their opinion is on debt, you would receive a wide variety of answers. Many people understand debt from a consumer perspective but not from a business perspective. The fact is almost all large businesses have used leverage to scale their operations and this is certainly true in the real estate industry. If you have ever wondered why this is true, the following thoughts might guide you in better understanding the reasoning behind the use of leverage.
1. Leverage allows you to achieve higher returns on your investment
One of the primary reasons to use leverage in real estate investing is that is allows you to achieve higher returns on money invested than you otherwise would receive. This in fact is why we call it “leverage.” To explain this principle, read the following example.
Let’s say you have $100,000 to invest in real estate. You find a house which costs $100,000 and will provide you with $7,000 of return each year. This means that after one year you will have received a 7% return on your investment.
Now let’s say that you instead take only $25,000 and you buy that same house but this time you borrow the remaining $75,000 from a bank at 3% interest. This means that you will have to pay the bank $2,250 each year in interest payments which will reduce your $7,000 return down to a return of $4,750. In this instance although you are receiving less return on this given house, you are making a 19% return on your $25,000 investment! Quite a large difference. This also of course means that with the same $100,000 you could purchase four houses which would give you a 19% return on the $25,000 investment for a total of $19,000 returned each year!
2. Leverage allows you to scale more quickly which reduces your risk
As seen in the example above, if you have $100,000 and choose not to use leverage you are limited to purchasing a single property. If you do use leverage in this example you can purchase four properties. This provides you with economies of scale which can make operational costs more efficient and reduces your risk against vacancy. If you own one property and it goes vacant you have lost 100% of you income whereas if you own four properties this would be only 25%.
3. Leverage places risk of inflation against the lender
Inflation is an economic term that is often thrown out with little explanation. The easiest way to understand inflation is that the value inherent to a particular quantity of money is reduced. This means that if you can purchase say a car for a given number of dollars today, a year of inflation at 3% would result in the price of that car being 3% more dollars than it is today due to inflation. When you borrow money, you are taking it from the lender and investing it at a given current value. If inflation then begins to devalue the dollar, the payments you are returning to the lender are the same amount of dollars, but those dollars do not have the same inherent buying power.