Investment Physics Law — Leverage — Most Misunderstood
Posted @ 12:34 am - Filed under Investment Physics, Leverage
Then the guy says to me, “What you just don’t get, BawldGuy, is that leverage is the foundation for all that is good in real estate. Why don’t you get that? In fact, the higher the leverage the faster the capital growth, right? Right.”
Where to begin. The depth of ignorance in those statements is staggering. How ’bout the basic definition of leverage in the first place?
I understand most folks view it as the ability to control property with very little of their own money. Fair enough. The lever moves the big bad boulder and all that. I get it. That’s not, however, strictly speaking, what investment leverage is — not even close.
It’s kinda like cash flow. We hear that term and immediately a picture flashes in our mind — green paper with large numbers and pictures of dead presidents — all coming our way.
Extra! Extra! Extra! There’s negative cash flow too. Oops.
Folks, I’m here today to let you in on a little secret: There’s negative leverage too. Sshhhh. Quiet. Don’t say it so loudly. Sorry.
Positive leverage in the strictest sense, is when your return on capital is greater than what you’re paying for the borrowed money you used to acquire the investment.
If your cost of money is 7%, and your return is 6% — you lose.
If on the other hand, your cost is 7%, and your return on capital invested is 10% — you win.
The first is called negative leverage, the second is positive.
If I put 10% down on a rental property with an interest rate of 7%, and my cash flow is negative after taxes, and there’s no appreciation — my so-called leverage is worse than…
The other guy who put 20% down across town, had break even cash flow, and 4% appreciation — his leverage was, by orders of magnitude, superior to my leverage.
Law: Leverage in real estate investing isn’t primarily low down payment. It’s ensuring your cost of borrowed money expressed in terms of interest, is less than the return on invested capital.
Violation of this law will produce consequences analogous to falling off a treadmill. At least while on the real estate treadmill, i.e.
no appreciation or cash flow, the tax shelter provides a little something of return on which to hang your hat. When the net result however, is that your after tax return is less than the cost of money — next thing you know you’re on the floor wondering what happened.
It’s not a good feeling. I’ve fallen off a treadmill, and in my time experienced some pretty negative leverage. The best thing I can report about both experiences is that I didn’t get hurt too badly. Both experiences were, however, painful — to the extent I have paid much more attention than before the mishaps.
The Myth: As long as your down payment is lower than the other guy, you’ll automatically make more money than they will.
That single belief, held by so many, has been the sand upon which many disasters have been built.
Of all the Laws of Investment Physics, this may be the most abused. The biggest abusers? Those who’ve tasted solid success using it correctly. The problem? The lesson they took from their initial success was — the erroneous conclusion that their use of leverage was the magic wand to riches. And that can be as irritating as this magic wand and hat. 
The Paradox: It can be one of the most effective tools in the investor’s tool chest. It can also devour capital faster than you can watch it happen. Which one you experience is almost always dependent upon actually knowing what it is — and maybe more importantly — what it isn’t.
And finally, I feel compelled to remind you of the obvious, but unstated corollary of this, and every other Law of Investment Physics: They’re called Laws and not Suggestions for a reason.
This entry was posted on Tuesday, September 18th, 2007 at 12:34 am and is filed under Investment Physics, Leverage. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.