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January 24th, 2017 by Marco Santarelli
Ignoring the fact that stocks, bonds, mutual funds, and other investments are either over-valued or providing negative real returns, real estate has almost always been the best use of capital specifically because of your ability to leverage your investment.
If used properly, leverage will significantly enhance your return on investment. This is easy to do if you invest in income-producing real estate but much more difficult, if not impossible, if you’re investing in stocks or mutual funds.
In our industry we often refer to it as “other people’s money” or “OPM”.
Let’s say you have $100,000 to invest. If you invest it in stocks, bonds, or mutual funds, you can only buy a $100,000 stake as a shareholder. However, if you invest that same amount in rental property – a quality single-family rental, duplex, or in some areas even a four-plex – you can leverage that same $100,000 into a much higher valued asset.
For example, you can purchase $400,000 worth of income-producing rental properties, use only $100,000 of your own money and the bank or lender will lend you the other $300,000 at a fixed interest rate amortized over 25 or 30 years. You now have positive leverage when the interest rate on your mortgage is lower than the overall return on the property. Compare this to investments in the stock market. It doesn’t even compare!
Let me give you an example. When you have $400,000 of rental property generating a net cash flow of $34,400 each year without any debt financing, that’s an 8 percent cash-on-cash return on your investment ($34,400 / $400,000 = .086 or 8.6 percent).
Now say you invest your $100,000 and borrow $300,000 at 5.0 percent interest, amortized over 30 years. The monthly mortgage payment is $1,610.46 per month or $19,325.52 per year, the net cash flow of $34,400 gives you $15,074.48 in net cash flow. That increases your return from 8.6 percent to 15.1 percent ($15,074.48 / $100,000 = .1507 or 15.1 percent).
By using leverage your annual cash-on-cash return increases by over 75 percent (15.1 – 8.6 = 6.5 / 8.6 = .7558 or 75.5 percent). Isn’t that amazing? That’s the magic of leverage!
Today banks and private lenders (via their self-directed IRAs or just private money) consider real estate a relatively safe option. In fact, compared to the stock & bond market real estate is not only safer but actually more profitable.
If your retirement account (IRA, 401k, etc) is not self-directed then you’re missing out on some great opportunities. Look into it, or contact our office to find out more.
There are, however, a few things to keep in mind as you use leverage to invest.
We just came through an era when investors got “OPM happy” and overdosed on cheap leverage for all the wrong reasons. Make sure your properties cash-flow and budget in possible vacancies.
Choose a high quality property in a good neighborhood. If you were investing with cash-only you could choose a more risky “up and coming” kind of property. But if you are using leverage choose an area where, even if rental demand declines, you could sell the property easily. Remember that rental property isn’t as liquid as stocks, bonds or mutual funds. A high quality property makes it easier if an emergency strikes and you are forced to sell.
My most valuable advice is be prepared for the business of owning rentals and keep in mind that it is most certainly a business. Get serious about your education and dedication to the business or hire a good property manager. Finding a good property manager or firm can be the most difficult part of investing.
Finally keep in mind that any investment that produces any reasonable return involves some risk. I believe that real estate isn’t nearly as risky as the current stock and bond markets (negative real rates of return anyone?) but there is always some uncertainty. Be honest with yourself to make wise choices.
Although I am not a financial advisor and cannot give any kind of financial advice, I will tell you that I have moved nearly all of my investments into real estate of some kind.
If the real estate holdings themselves are not your cup of tea you may want to consider being a private lender yourself. Experts will tell you that a balanced portfolio is best. I believe that adding real estate, in some form, to whatever investments you prefer will bring you far greater returns than stocks, bonds, and mutual funds alone could bring. I speak from experience when I say that using a little leverage for income-producing rental real estate can build wealth much faster than other traditional options.
Just remember, it’s “the magic of leverage.”
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