Mathematics of Financial Leverage
The mathematics of financial leveraging has always been very seductive to Real Estate Investors. This is more so at the time when markets soar. With leveraging, one uses other people’s money to enhance his own profits by acquiring additional interests in real estate
This enhancement process takes the form either of added equity, which is realized at the time the real estate asset is sold, or as additional cash-flow, as in the case of rental properties. Either way, mathematics of Financial Leverage
Makes a compelling case for borrowing against home equity to invest.
There are leveraging risks that must be understood by an uninitiated investor. For one thing, while leverage allows greater potential return to the investor than otherwise would have been available, the potential for loss is greater because if the investment loses value not only is a portion of that money lost, but the loan still needs to be repaid in its entirety.
It is therefore important to understand the mathematics behind financial leveraging to avoid making mistakes.
How much worth of real estate you can buy with $100,000? Clearly you can buy $100,000 worth of property in a cash deal. You can also buy property worth $200,000 by borrowing 50% of the purchase price. If you are more innovative you can buy $400,000 worth of property by taking out a 25% mortgage or better still you can buy $1,000,000 worth of property by taking out a 90% mortgage. This is interesting mathematics.
Let us say you buy a house of $100,000 in a cash deal with no borrowing. Let us assume that your tenant is paying $8000 in rent. The operating expenses that include the rates and maintenance cost come to $3000. You are now left with left with $6000 as cash flow from the rent. If your property appreciated by 10% during the year that is to $110,000. You will have a return of $16,000 ($5000 cash flow from rent + $10,000 in capital appreciation). This will mean that you will have a return of 16% on your investment of $100,000.
Now let us say that you decide to leverage your money and take out a mortgage of 90%. The bank will loan you $900,000 on your deposit of $100,000. You now have $1,000,000 and you decide to buy ten houses with each house valued at $100,000 as in the previous example. Let us assume that your rent of $80,000 from the 10 houses covers the expenses $30,000 ($3,000 X 10 houses) and the mortgage payment of $ 45,000 (5% interest only loan on $900,000). You will be left with $5000 cash flow from the rent. If your ten houses appreciate by 10% as in the last example to $1.1 million your return from your investment will be $105,000 ($5000 cash flow from rent + $100,000 in capital appreciation. This will result in a return of 105% on your initial investment of $100,000. This part of mathematics of financial leveraging that is so seductive to property investors
The after tax returns on a leveraged property will be much higher because you will be able to claim depreciation and maintenance costs on ten properties instead of one. Also the interest paid on borrowed funds of $900,000 can be claimed back to increase the tax refunds.
The above mathematics clearly shows how you can increase your net returns dramatically by leveraging your money.
But we should also examine the downside mathematics of financial leveraging. Let us say the property values went down by 10% in a year instead of going up in the previous example. In the case of a cash deal our loss will be $4000 for the year thereby giving us a negative return on investment of 4%. On the other hand we will suffer a loss of $95,000 or 95% of the value of the deposit in case of mortgage of 90%.
The losses get amplified in case of a leveraged property. Is it advisable to risk financial leverage in buying property? The answer to that question is a simple YES.This is because values of properties have appreciated steadily at 8% to 10% annually during the past 300 years. There are dips in the property cycle but these are far and few in between. If you have the capacity to buy and hold and manage your cash flow you will win in the end.
Please also read about Mathematics behind Leverage, Cash Flow Leverage, Appreciation Leverage, Leveraging Risk and how you can contain these risks.
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