This is an excerpt from my forthcoming book, Growing Equity. My goal is to demystify the process of analyzing and buying income producing real estate without the condescension of the “Dummies” books.
Give me a lever long enough and a fulcrum on which to place it, and I shall move the world. Archimedes
We are all familiar with the concept of the simplest of all machines: the lever. Our most distant ancestors found that they could use a stout tree branch and a small log for a fulcrum and move huge boulders with little effort. They were able to multiply their own limited strength by many times. A ten foot lever with a fulcrum one foot from the end will multiply the user’s force nine times.
Financial leverage works the same way. A small investment plus financing controls an appreciating asset. The owner’s equity increases at a rate higher than the increase of the whole asset.
Here are some examples:
You have $100,000 cash to invest. You buy a piece of land for $100,000—no mortgage. Over some period of time, the land appreciates 10%, and it is now worth $110,000. Your equity is now $110,000. 10% appreciation gave you a 10% increase in your equity.
Or you could take the same $100,000 cash and use it to make a 25% down payment on a $400,000 rental property. You take out a mortgage for $300,000. The property appreciates 10% over the same period the $100,000 land did; it is now worth $440,000. I will disregard the monthly payment and the payment toward principal for this example. Where you started with $100,000 equity ($400,000 minus the $300,000 mortgage), you now have $140,000 equity ($440,000 minus the $300,000 mortgage). Your equity has grown by 40%, even though the property itself has only increased in value by 10%. This is the value of leverage. As our buddy Archimedes might say, Eureka!
These two examples are obviously oversimplifications of what really happens. If you borrow money, you have to make monthly payments on the loan, and those payments reduce the money left over from the rent you collect after paying all the expenses of the property. So let’s look at cash flow, and how it works.
(continued in Part 3)