Cash Flow Investors: Introducing the Concept of Leverage

Leverage (n. – lev-er-ij): the use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one’s investment, to control a much larger investment, or to reduce one’s own liability for any loss.

The concept of leverage is a powerful tool that can provide many benefits for an investor’s portfolio, if used correctly.  The definition above highlights 3 key advantages: potential for higher returns, larger investments, and reducing personal loss exposure.  Successful real estate cash flow investors understand this concept and have created tremendous wealth.  Robert Kiyosaki, New York Times bestselling author of Rich Dad, Poor Dad and real estate investor, teaches about how leverage can be used to generate wealth.  In his book, Retire Young, Retire Rich, he states that his rich dad once said “the most important word in the world of money is cash flow.  The second most important word is leverage.”  This article will explain how financial leverage ties into buying investment properties and the power it can yield to cash flow investors.

Cash Flow Investors: Using Leverage to Acquire Real Estate

What are some of the ways cash flow investors acquire real estate?  Cash, traditional mortgage financing, private (or hard) money, self-directed retirement accounts, equity funds, lease option contracts, and seller financing just to name a few.  All of these, outside of cash and self-directed retirement accounts, have to do with a type of financial leverage.  Based on this observation, it is safe to say that leverage plays a crucial role in the real estate acquisition process.  The following story illustrates the use of leverage in purchasing real estate.

Cash flow investors use the power of leverage

Jim, like many other cash flow investors, is looking to take advantage of the distressed Arizona real estate market.  He recently ran across a real estate agent who works with several institutional lenders selling their REO properties.  Jim has $100,000 in liquid cash that he is looking to invest.  The agent has several listings; however only two properties in North Phoenix fit into Jim’s price range.

Property A is listed at $100,000 and Property B at $96,000.  Both are 3 bedroom/2 bathroom single family homes that rent for approximately $900 per month.  Jim needs to decide which propertywould make the better investment.  What should Jim do?  The information below will analyze Jim’s options.

Jim’s Cash vs. Leverage

His first option is to pay cash.  This will only allow him to purchase one of the properties.  Jim decides to purchase Property B, since it is priced $4,000 cheaper but still produces the same monthly income.

His second option would be to visit his mortgage banker and take out a mortgage.  He takes out 2 loans, one for Property A and another for Property B.  He still wants to utilize his $100,000, so he puts money down on both properties

These examples provide a good illustration on the use of leverage in acquiring property.  The next section will cover the advantages of Jim using leverage and what other cash flow investors can learn from his situation.

Cash Flow Investors: Advantages of Leverage

As we discussed in the introduction to this article, there are 3 key advantages to using leverage.  They are the potential for higher returns, control a larger investment, and reduce the risk of loss for cash flow investors.  In following Jim’s decision to purchase investment property, the examples above provide some valuable information that can be used when looking at the advantages leverage presents to cash flow investors.

Leverage can create higher returns for cash flow investors

The first advantage is the potential for higher returns.  Jim’s option to purchase Property B all cash would result in a ROI of 11.25%, which is a very attractive return.  The other option, the option of using leverage, would now allow him to purchase both Property A and Property B yielding an average ROI of 15.05%.  Returns are calculated based off of Jim’s personal capital invested. The power of leverage is evident here, as Jim would see almost a 4% greater return than using all cash.

Another advantage is the ability to control a larger investment.  Using leverage, investors have the ability to purchase properties that may require more capital than they have personally to invest.  This technique must not be abused because investors can quickly find themselves over-extended.  In Jim’s case, the use of leverage allows him to purchase both Property A and Property B.  A larger investment portfolio in of itself provides additional benefits, one being diversification.  In dealing with rental properties, cash flow investors have to cope with the possibility of vacancy.  A diversified real estate portfolio allows an investor to weather periods of vacancy, while still maintaining cash flow.

The third key advantage is minimizing an investor’s exposure in the case of a loss.  There is risk in any investment, even in real estate. The potential for vacancy (used in the previous paragraph) can help illustrate this point. If a property is vacant, then this would be considered a loss of income for an investor. In the example with Jim, assume he has a tenant paying $900/month in Property B; however he is unable to find someone to rent Property A. Each month that goes by, Jim is facing a loss of income and actually paying a $227.12 mortgage payment. Because he is drawing income from Property B, he is still able to receive a return of 4.25%. Compare this with using the all cash option, Jim would actually have a ROI of 0%. With the use of leverage, he is at least able to create a positive cash flow and see an above-average return.

After discussing Jim’s situation, what is his best option?……

The purpose of this article is not suggesting investors go out and accumulate loads of debt, as there is a big difference between good debt and bad debt. This article was written to explain a powerful tool that cash flow investors can use to create success within their real estate portfolios. Now that you understand the power of leverage, it is important to see what opportunities are available. Learn how Clear Vision Investment Group can help you locate profitable cash flow investments.