Benefits of Leverage:
Why do people who have millions of dollars to invest still adamantly pursue the procurement of debt for real estate investments if they can afford to buy something with 100% cash? There are many complex reasons including tax benefits, allocation diversification of equity, etc, but the simple reason is to boost the return on the investor’s equity.
The ensuing simple example demonstrates the positive effects (although it is possible for negative effects) of leverage (aka debt).
An investor is debating purchasing a 1,000,000 dollar asset that produces a cash flow of 100,000 annually. Should he take his 1MM dollars and buy the thing 100% cash free and clear. If he pursued this avenue he would achieve a 10% return on his equity 100M/1MM. 10% nowadays seems like an attractive deal, but what if the investor withholds 800M and only invests 200M. The other 800M to acquire the property is obtained via a loan from a bank. The bank’s nowadays may not loan this much but let’s continue with the example. This 800M dollar loan is at a rate of 7% annually which translates into a total payment of 67,850.80 per year. So to get to the crux of the matter you take in 100M a year from your property and dish out 67,850.80 to the bank. Your remaining proceeds are 32,149.20. This means an annual return of 32,149.20/200M which is a 16.07% return on your equity which far exceeds the all cash purchase of the property. As you can infer this return is bettered with a lower bank interest rate/more bank money but can be hurt by a higher rate/less money to the point of something called negative leverage which I will discuss next post.
Cheers,
John
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