Using a Little Stick to Move a Big Rock.
This is the description of leverage most common in Physics classes. Then you have the diagram: a person using a stick with a little rock underneath it to move a big rock on the other end.
The physical principle of leverage is very simple. A smaller weight over a long distance, when applied to the long end of a lever, can move a larger weight a small distance. Hence, a small man can move a rock larger than himself through the use of a lever.
The Principle of Financial Leverage
Financial leverage is similar to the physical concept. But instead of using a smaller weight to move a larger weight, a smaller equity investment is used, in combination with debt, to purchase a much larger investment.
Leverage has the effect of multiplying the return on investment, whether positive or negative. With a smaller initial equity (cash) investment control is gained over a larger investment and the returns on that larger investment are reaped.
Let’s look at an example. The first model is the purchase of a $100,000 investment with $20,000 of equity and by borrowing $80,000. The second model is the purchase of a $100,000 with $10,000 of equity and by borrowing $90,000. You will see two scenarios, one with 10% gain, the second with a 20% gain on the investment.
| Equity Investment | Debt | Total Investment | % Equity | New Investment Value | Percent Gain | Dollar Gain | Return on Equity |
|
$ 20,000
|
$ 80,000
|
$ 100,000
|
20%
|
$ 110,000
|
10%
|
$ 10,000
|
50%
|
|
$ 10,000
|
$ 90,000
|
$ 100,000
|
10%
|
$ 110,000
|
10%
|
$ 10,000
|
100%
|
|
$ 20,000
|
$ 80,000
|
$ 100,000
|
20%
|
$ 120,000
|
20%
|
$ 20,000
|
100%
|
|
$ 10,000
|
$ 90,000
|
$ 100,000
|
10%
|
$ 120,000
|
20%
|
$ 20,000
|
200%
|
As you can see from the table, a return of 10% generates a 50% return on equity with a 20% investment. A return of 10% generates a 100% return on equity with a 10% investment. Debt always comes at the cost of interest. When the interest cost is less than the total return, a greater return on equity should be realized through the use of leverage over not having used leverage.
Leverage has a similar multiplication effect when an investment has a negative return. This means that you can lose more than your initial investment if the negative return is significant. Hence, leverage should be used cautiously and prudently.
This can mean reap huge rewards for a real estate investor. Imagine an investor with $100,000 of capital for investment in addition to their Sominex Account. With this capital as a 20% down payment they can purchase roughly $500,000 of investment property. Assume the property appreciates at a (moderate) rate of 8% per year for three years. At the end of the three years the equity in the property has increased over $120,000, a return on equity of 120%. When was the last time your IRA performed so well?
Now with close to $220,000 (initial $100,000 + $120,000) in equity the investor can gain control of $1,000,000 in investment property. If the $1,000,000 in investment property appreciates at the same 8% rate, the equity will grow by $80,000 per year.
Hopefully, you can see that real estate leverage can significantly increase return on equity. It needs to be used wisely and in accordance with a well developed plan. Using debt foolishly is called speculation and is the fast-track to foreclosure and ruin.
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Responses to “Real Estate Leverage”
March 6th, 2008 at 1:04 pm
Regarless of the type of real estate investing you are considering doing. Based on my 6 years of investing experience, people who are educated in the investing process and understand investing strategies are the most successful. I came across some free investment strategy videos and this ebook that I thought would be cool to share with everyone. You can download it at http://www.SamBell3rd.com . Happy investing and I hope this resource is a benefit for you.
July 14th, 2008 at 11:25 am
Without a doubt, leverage can help you buy more real estate. Using other peoples money to buy real estate is a fundamental concept every real estate investor should know. Great explanation, Peter.
August 12th, 2008 at 10:28 am
Great little article I have been reading the Rich dad Poor Dad books and Robert is always talking about leverage to purchase property but you article explained it in nice simple terms with the table to highlight the potential. A lot of people are concerned with owning a lot of money on mortgages etc… but as Robert points out in his books if you can generate positive case flow and the property steadily appreciates in value then hey purchase as many as you can manage. Using leverage and OPM (other peoples money to purchase real estate has made a lot of people rich and in my opinion it is the best way to become a successful property investor.
August 24th, 2008 at 6:33 pm
but what about interest on the loan? if I borrow for 3 years, wouldnt the loan person/institution also want their cut? Otherwise, I could be a rich man.
This only seems to work if I can immediately turn the property around for a profit, all while promising the investor a set amount (e.g. 10% annual).
wish there was an easy way to subscribe to followup comments on this post.
–sidenote–
maybe if you investd in a house, and required the person who you were buying from to use your bank (to save the money), then you could leverage that way as well.
September 9th, 2008 at 7:39 pm
As you mentioned, leverage works both ways. So while it’s a tool you’ll probably have to use if you want to accumulate large amounts of wealth, it’s not a case of higher reward without the associated higher risk.
September 9th, 2008 at 11:07 pm
Thanks all for responding to my post.
- Buy Home Insurance – in the examples that I gave I am assuming that the property is “cash flowing”. This means that the tenants of the property are paying enough in rent to pay for the mortgage, insurance, management and repairs.
- Accumulating Money – You are correct greater rewards requires greater risk. Leverage has the same multiplication effect in reverse if the property were to go down in value. This can quickly deteriorate or eliminate the borrower’s out of pocket investment.


April 30th, 2007 at 7:13 pm
Thanks for the nod big guy. I’m starting to wonder if I had two sons.