Leverage (Other People's Money)

Leverage (Other People's Money)
Leverage means making every dollar count, although simply stated it is:  Borrowing money to improve one's rate of return on an investment.

It always reminds me in some ways though of the movie Fargo, where the main character is always saying, 'this is my deal here', in his upper Midwestern accent.

JERRY:  No, but, Wade, see, I was bringin' you this deal for you to loan me the money to put in. It's my deal here, see?

But the best way to make each and every one of your dollar count is to pool them with other people’s money. Why?  Because the more money you’ve got to work with, the more opportunities that are within your reach, and the likelier that you’ll be able to purchase a property that will make you money.

Let’s crunch simple some numbers in a hypothetical example and see how leverage can make a difference.

Scenario 1:
Without leverage, you purchase a property for $150,000. If there is an appreciation rate of 6% per year, two years later, the property is worth $168,540. Your profit in appreciation: $18,540.

Scenario 2:
With leverage, you combine your $150,000 with $450,000 of other people’s money, giving you the ability to purchase a pricier property at $600,000. With the same appreciation in the same amount of time, the property value goes up to $674,160. Your profit in appreciation: $74,160.
Because you orchestrated the deal and made the profit, you get to keep the majority of that profit and still make a lot more money with leverage than without.

The power of leverage is especially strong in real estate. Other people are more likely to let you invest their money when you’re dealing with real estate as opposed to any other type of investment. Banks, for example, are much more willing to go out on a limb and give you a loan if you’re buying property than if you’re buying stocks, because they know that if it doesn’t work out and you don’t pay up, they have something tangible that they can take from you. Not only can they take it, but they can also sell it themselves and recover their losses, because of the value of property generally goes up. If you use the bank’s loan money to invest is stocks that end up being a big flop, there’s not much they can do to get their money back!

You can increase the power of leverage by building your “trustworthiness” as an investor. After all, you’re expecting other people to let you invest with their money, and they’re expecting you to do a good job. They need to know that they’re better off putting their money in your hands than in investing it themselves, and they need to trust that you’re operating in their best interest—to turn a profit.

The most evident way people have of measuring your trustworthiness is by seeing if you have a strong credit history, which encompasses not just your finances, but your character, references, and proof you will pay. With a good credit history, you don’t have to use as much cash to buy a property but instead can leverage other people’s money (in the form of a loan) to make a purchase and start making money both through cash flow and appreciation over time.

If you are going to invest with other people’s money through loans, you can measure the leverage of a loan with a loan-to-value (LTV) ratio. LTV is the ratio of borrowed funds to the total purchase price. The higher the LTV, the greater your leverage. As an example, let’s say you’re considering a property that costs $750,000. A loan for $700,000 has an LTV of $700,000 divided by $750,000, which equals 0.93. Compare that with a loan for $600,000, which gives you an LTV of 0.80. A bigger loan means a higher LTV, which means more of other people’s money to leverage your investment.

However, loans aren’t the only way you can gain access to other people’s money. You can also bring in partners, who will enter the deal with you more as participants rather than as observers. They will still judge you by the same criteria as lenders would, and will want to see proof of your ability to evaluate properties and be financially responsible.

Once people have entrusted their money with you, it is important to be as financially responsible as ever. Don’t let leverage or loans give you a false sense of security. Be just as careful with other people’s money as you are with yours. Once you have the money to buy property, you need to maintain fiscal responsibility and have a strict budget.

No matter how much money you have tied up in a deal, and no matter how much of it is yours or belongs to others, you want to make sure you have some cash in reserve, for the unforeseen cost of a roof that needs fixing or a slow period in the market, where you have to wait out a lull in the property’s appreciation. Anyone can spend money but not everyone can save. Abide by this dictum, because it will cushion the bumps on your way to real estate investing success.

Source