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Leverage

DEFINITION

Securing financing from the collateral of a property to purchase the property with little money down.

EXPLANATION

Leverage is the most common form of home purchasing power. Leverage utilizes existing equity and the value of property to get a loan, refinance an existing loan or get cash out from property.  A prospective home buyer can buy a home with a minimum down payment of 3.5% (through FHA loans) or a minimum of 20% through traditional lenders. Homeowners can leverage the value of their property at any time by selling their home, subsequently paying off the lender owed money and profiting the difference between the final sale amount and the loan amount.

How Leverage is Used

Property owners can retain a second mortgage on their property by utilizing the equity in the home. This is known as leveraging equity. Assuming the homeowner has solid income and good credit, qualifying for a mortgage with equity is achievable. The maximum loan to value ratio (LTV) that lenders typically accept for loan qualification is 70%.Leverage for a Property Owner

For example, a property owner whose property is valued at $1,000,000 can have a maximum loan amount of $700,000. In this example, $700,000 is 70% of the property value, therefore the borrower would not qualify for a loan anything above that amount. Lenders do not lend on anything higher than 70% because in the event the borrower can no longer afford the property, the lender will have the means to sell the property to recoup the loan amount back.

Leverage benefits both lenders and property owners because it gives them the ability to either make money or own a property without paying the full amount. Leverage utilizes the value of the collateral to retain some form of financing or money back.

Example

The Manson family bought their home in 1998 for $200,000 with a $40,000 down payment. The Manson’s decide to remodel their home leveraging its equity to remodel the home. Because of the renovations the home’s property value increased to $300,000. Beginning in 2000 their property value began to increase dramatically. Their home once valued at $200,000 in 1998 is now worth 1 million in the year 2013.

The initial investment of $40,000 allowed them to create over $800,000 in equity in addition to the fact that property values grew, while simultaneously living in the home during this period.  Again, there is no investment that gives borrowers the ability to make money, while also giving them a place to live at the same time.

Example

Following the increase in property value, the Manson’s decide to take a second loan on the home for $90,000. This loan will be used to start a new business.

As seen above, the homeowner has the ability to leverage their home to make more money by taking out their equity that has built through the years. The greatest benefits of owning a home are greatly realized when a homeowner takes out cash from their equity or when they sell their property. The example above is one of millions of true life stories that occur all throughout the real estate market. This example displays a potential scenario that can occur anywhere and by anyone when owning a home. Without the initial loan to buy the home in 1998, the Manson’s could never have bought the home, let alone make money on it or start their new business. The importance of financing for the health of the overall economy cannot be understated.

The Manson’s directly benefited from the acquisition of their property and so too did the economy with their investment in a new business. Understanding a connected economy will help the agent and broker make better decisions.

Common Reasons a Property Owner Utilizes Leverage

Leverage gives property owners the ability to get cash out from their property. Money taken out as a second mortgage can be used for multiple reasons including making repair, starting a business, paying down debt, and/or spending money on an emergency.

It is common for real estate investors to leverage the equity in a property they already own with the intent of using that money to purchase another investment property. Using the equity in one’s property is the best way to increase your net worth. While it sometimes may be advantageous to not retain a second mortgage for the purpose of buying another one, using a second mortgage to purchase more property is one of the main ways real estate investor leverage their net worth to make more money.

Example of Using Collateral

Jason wants to make money and decides to invest in real estate. He purchases a property for $1 million and puts down $200,000 towards the purchase. His initial $200,000 investment makes him $100,000 a year in rental income after expenses. The interest he pays his lender is $35,000 per year while he pockets $65,000 per year. This means his initial $200,000 investment made him a $65,000 profit in only one year. This is a nearly 35% rate of return, which is staggering. Had Jason decided to purchase bonds or put his money in the bank he would have earned a maximum rate of return of 3-5%. As this example demonstrates, leverage has the ability to make investors large sums of money in a short period of time.

Risk of Using Leverage

While the example above proves that leverage can greatly increase one’s income in a relatively short period of time, leverage does carry some risks. If not invested correctly in the proper real estate market at an opportune time in the economic cycle, leverage can create great financial distress. Leverage can drastically exponentially increase the rate of return and the speed at which a party can make money on their investment. When invested incorrectly or at the peak of a market cycle, leverage has the ability to magnify financial ruin due to the increased debt load. Current economic conditions and the events of the market place also greatly affect the exponential rise or fall of a party’s investment.

The Great Recession of 2008 caused many real estate investors and property owner that had their great financial ruin. During this period, a significant amount of real estate owners maximized the leverage in their properties believing that the value of property would continue going up, however the opposite occured and instead property values went down. This caused many property owners go become upside down on their mortgage. Being upside down on an investment is when a party loses money because their loan amount, which is the money they owe is higher than the value of the property.

Famous Investors that Have Utilized Leverage to Their Advantage

Leveraging the equity in one’s property or getting a loan to purchase a property is one of the major business strategies that many of the top investors to use to exponentially increase their net worth. There are two noteworthy investors who have increased their businesses net worth dramatically using leverage.

Warren Buffett and Donald Trump are two prime examples of successful businessmen that use leverage to greatly increase the speed and value in which their businesses make money. Although both Warren and Trump use leverage to increase their net worth, they differ in the manner, leverage ratio, and amount of money they leverage. Warren has a more conservative long-term approach, whereas Trump is more aggressive with his use of leverage.

Warren

Warren has a very conservative approach to leverage, never wanting to take on too much debt. His belief stems from the fact that debt should only be used sparingly and with purpose. Rather than cashing out on his net worth with the idea of reinvesting those earnings, Buffett rejects the notion that every deal need leverage and more debt.  Buffett’s main form of leverage includes deferring taxes and keeping his investments long term rather than constantly pulling out cash. Buffett invests in businesses he believes will be and remain successful, rather than trading on speculation and quick earnings.

In its current state, Buffett’s Berkshire has less than 20% debt, which is very low for a businessman, especially considering it is possible for him to retain at least 70% debt as compared to the value of his business. Warren believes in a long term low rate fixed leverage approach as opposed to riskier short term more expensive rates.

While his income level might not increase as exponentially as say a higher leveraged game plan in the short term, his long-term approach has made him one of the most successful investors in the world. His patience and business acumen in investing in the right companies and his risk averse strategy has helped him rarely if ever make investments that have not panned out in his favor. His strategy is much different than Trump who operates on the notion that maximum leverage is key to development.

Trump

Donald Trump has leveraged debt to his advantage by cashing out on his assets to purchase new property. This strategy has helped him have the capital he needed to build his massive hotels and business empire. Trump is known for taking on riskier short term leveraging strategies with the idea that after the building or hotel he built using leverage would have cash flow to cover his debt and spending expenditures.

The main reason Trump’s leveraging strategy works is that it gives him a significant amount of working capital to invest in his businesses, buildings, and golf courses. In real estate, using less leverage proves difficult because without it the investor would not have enough money to develop properties that deliver high cash flow.

The major detriment of leveraging to one’s capacity like Trump is that in the event of a real estate market downturn, the borrower still owes the high debt while values go down. This can prove difficult for many businessmen to withstand, even for Trump in instances such as when his casino ventures in Atlantic City failed because of the high debt and low cash flow. Trump’s use of leverage has given him the ability to greatly increase his net worth, and at the same time placed him in precarious situations such as when he filed for bankruptcy.

Notes From Warren and Trump’s Leveraging Strategy

Warren Buffett and Donald Trump utilize leverage to their advantage and made significant gains doing so. While Buffett has a more conservative approach to leveraging debt and Trump has a more aggressive strategy on getting capital, both investors have greatly increased their net worth’s.

There is no right or wrong approach to leveraging capital, however the general rule that Buffett employs by and large is safer for the bulk of investors because it is a less risk averse strategy with a smaller chance of causing financial ruin. Trump’s strategy of maximizing the power of leverage works for him because he understands his business very well and even he has made errors along the way, however for many investors employing Buffet’s strategy of using long term, minimal to moderate leverage is often a safer and smarter choice.

Applying Buffet’s Low Risk Strategy for Real Estate

While the bulk of Buffett’s investments have not been in real estate, there is much to say about his approach to low risk long term leveraging.

The main benefit of Buffett’s investing strategy is that there is little to no risk of investing for long term growth as property values always go up in the long term. For example, assume an investor purchases a property with all cash. Even if the investor overpaid for the investment, the fact that they paid in cash means they would no lose money in the property. In fact, if the value of the property decreases temporarily, in the long term the value would increase, and the investors investment would be safe.

On the converse, if an investor purchased a property leveraging a significant amount of financing for the purchase and the value of properties went down, the investor would likely lose money because it would take a significant amount of time for values to increase. Clearly this strategy can prove disastrous, however as noted above, without leveraging many purchases would not be possible.

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