Latest / Cash Flow for Life / Chapter 4: Leverage and Using It Wisely
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- 00;00;00;06 - 00;00;22;14 Chapter four leverage and using it wisely. At this point, you should have a really good idea of what you know and what you need to learn and what your current financial resources are to get you started with real estate investing. You've already begun a plan to work on your financial position in order to free up cash and real estate investing. 00;00;22;19 - 00;00;50;27 You've downloaded the resources we put together to help you do this, and even if you're cash poor and just getting started. You can expect more resource tools from us later in this book. For the moment, though, let's assume you have the down payment or more in cash for the purchase of your first rental property. This will help us talk to you about leverage and the use of OPM or other people's money. 00;00;51;00 - 00;01;16;23 Leverage is a good thing. The US housing and mortgage markets took a huge hit in the period from 2007 through 2010. There were plenty of stories about careless lending practices and risky loan products. All of that bad news could lead one to believe that borrowing and leverage are not a good practice. Now, this couldn't be further from the truth. 00;01;16;25 - 00;01;37;23 Assuming for the moment that your filthy rich, we mean sitting on millions, maybe even billions of dollars. You want to put that money to work, but you don't want to do it in a risky way. You want to loan your money to people who will pay it back with interest that you can count on for years to come in the future. 00;01;37;26 - 00;02;02;03 Historically, home mortgages have been the most secure forms of investment. People will put off a lot of things and be laid on virtually any other payment, but they will always try to make that house payment on time because they need a place to live. Nobody wants to lose his or her home. So your money looks like it will work best for you at low risk by lending it to people buying homes. 00;02;02;05 - 00;02;27;04 Now add to your money the money of millions of other people with less wealth. Who by mutual funds or stocks that invest in mortgages. Suddenly there's a whole lot of money looking for borrowers. Add some government guarantees to lenders at lower risks and you have an abundance of money. Looking for someone wanting to buy a home with leverage. 00;02;27;07 - 00;02;50;25 The mortgage industry is gigantic because it's good for all the participants in the economy, and it's going to be great for your real estate investing business as well. If real estate rental property investing required a full cash purchase for every rental home, there would be very few homes for rent out there and very few places for people to live. 00;02;50;28 - 00;03;11;09 Even if you have a large amount of cash, do you want to buy a home for cash and rent it out? Maybe, but you could do a lot more if you use leverage. It's always better to own a small piece of a big asset. You get paid for the entire asset with just a small amount of your money down. 00;03;11;11 - 00;03;42;03 That's leverage. Leverage. Examples. Remember that this book is all about lifetime cash flow. Plus, we want to remember all of the other great benefits of rental property ownership. It would seem that multiplying our properties would also multiply our benefits. This is true as long as we do it well and with prudent investment. Principles and strategies. Example number one no leverage. 00;03;42;05 - 00;04;12;14 Here is an example situation. You're a real estate investor sitting on $100,000 in cash. Yes, we know that in some markets $100,000 could buy you for properties. And in other markets it's a parking space. We're just using this number as an example. You want to purchase a rental home and you want to pay for it cash. You know that you can get a renter into the home with a monthly rent payment of $650. 00;04;12;16 - 00;04;38;15 Now, let's keep things simple and focus only on leverage. We'll work these examples with only the principal and interest payments, and we'll ignore the other expenses like taxes and insurance. For now, just to talk about leverage, we'll get into those later in this book. Also, we won't consider closing costs. So in our example we have no mortgage payments going out and rent payments of $650 coming in every month. 00;04;38;18 - 00;05;00;12 We also know that we'll see some appreciation in the value of the home over time, and that we'll get a tax break or two for expenses related to the ownership and management of the property. However, because we don't have a mortgage, we won't have mortgage interest deduction. Let's do the calculation for simple return on investment in cash flow. 00;05;00;14 - 00;05;36;00 The cash flow is $650 per month. Times 12 months equals $7,800 per year. There's $100,000 investment. So $7,800 return divided by the $100,000 invested equals a 7.8% return on investment. Remember that we're ignoring other expenses and taxes to simplify our comparison. So this return looks better than it would be in reality. However, we'll do the same for our other calculations in the following examples. 00;05;36;02 - 00;05;41;12 In order to focus solely on the effect of leverage. 00;05;41;14 - 00;05;55;23 So an example one. With no leverage, we get a 7.8% return on investment leverage. Example 250% leverage for two homes. 00;05;55;26 - 00;06;25;19 Now you've decided to buy two homes with a mortgage instead of one home with cash and no mortgage. So instead of taking the $100,000 and buying one home, we'll take $50,000 and $50,000 and put them down on each of two homes. We'll assume that there's similar $100,000 homes, and the both rent for the same $650 per month. Let's pick an interest rate for this example. 00;06;25;21 - 00;06;57;14 Let's say you can get a mortgage on each of these homes for 5.25%. So if you're borrowing $50,000 per house, each of the homes would be purchased with a monthly mortgage payment of $276. Because our rents are the same at $650 in the previous example, we're realizing a cash inflow of $7,800 each, or $15,600 a year for both the properties. 00;06;57;16 - 00;07;40;21 The payments total $6,624 a year for both properties. So we have $15,600 in in rent coming in, less the $6,624 going out. This leaves a cash flow of $8,976 for the year. Now doing the same math in example one, let's take $8,976. Let's divide it by the amount that we've invested, which is $100,000. And we can see our ROI is 8.97 or rounded up to 9% return on investment. 00;07;40;23 - 00;08;14;29 We've still invested the same $100,000, but now we have more than a 1% better return on investment. That $748 a month, or $374 each month in cash flow for each home. We've used OPM other people's money to add money to our monthly take. All of the other benefits of rental property ownership are still in place, and we can now deduct the interest payments on the properties from the income as well. 00;08;15;01 - 00;08;42;05 Better than that, we now have two homes that will enjoy value appreciation. That appreciation will not be diminished by the fact that we took out mortgages that we leverage to buy them. We've increased our yield and doubled our anticipated appreciation gains. So we're gaining 200,000 in assets. We're controlling $200,000 in assets with the same $100,000 of our money. 00;08;42;08 - 00;09;19;15 That's leverage. We've doubled our money in asset control. Leverage. Example three three homes with 67% leverage. We're now going to borrow $67,000 on each of the three homes, or 67% loan to value on $100,000 home. We'll stick to our mortgage interest rates and rents from the previous examples. So let's see how it breaks down. Three loans at $370 a month times 12 months equals $13,320 a year in outflow. 00;09;19;19 - 00;10;04;00 These are loan or mortgage payments. We have three properties. So now we have three renters paying $650 a month for 12 months. That equals $23,400 a year in inflows. This is money coming in 23,400, in inflows minus R, $13,320 in flow equals $10,080 a year in cash flow, $10,080 a year in cash flow, divided by our same $100,000 investment equals 10.08 or rounded to 10% ROI. 00;10;04;02 - 00;10;26;27 You can see we've added to our ROI over the purchase of two homes, and definitely over the purchase of a single home with all cash. Now, in all of our examples, we have all of the other tax and rental property ownership benefits still in place for all three properties. We went from a monthly cash flow of $650 to one of $840 per month. 00;10;26;29 - 00;10;54;27 We gave ourselves almost a $200 raise with this same amount of starting capital. Now, while this might not seem like a big jump in cash flow, we're going to be anticipating appreciation now on $300,000 in assets, which is three times what we would be getting based on a single purchase. In other words, our $100,000 is now controlling $300,000 of assets. 00;10;55;00 - 00;11;28;26 Now we're going to stop with this third example, but you can see how this gets more powerful. The more leverage you use. We can go and take that $100,000 and buy for properties instead of 3 or 5 properties instead of four. Every time you spread that $100,000 over additional properties, your ROI, your return on investment on cashflow goes up and your return on investment on the appreciation goes up because you're getting paid appreciation on additional assets with the same amount of $100,000 down. 00;11;28;28 - 00;12;05;22 That's the power of leverage. Deeper analysis of our examples, our examples to illustrate leverage were just that. Examples, however, would they have been good investments? It should be obvious now that leverage can be a really great thing for the rental property investor. However, it must be used intelligently as too much leverage can backfire on the investor. Later, we'll show you how to look at return on investment and monthly cash flow with a much more fine tuned approach. 00;12;05;24 - 00;12;33;18 In fact, buying three homes with these numbers may not have been a good idea. Taxes, insurance, and expenses might have dramatically reduced your cash flow, maybe even to negative cash flow, which we never want. The examples were to show the effects of leverage. Getting more in rents or paying lower mortgage interests may have made these viable investments, but that's why we want you loving the numbers, not the house. 00;12;33;20 - 00;13;00;08 Our mandatory goal is to eliminate for you the expensive process of trial and error. Trial and error with leverage isn't something you want to do. We're going to make sure that you know how to get to use the real numbers, and use them to avoid leverage errors. Using leverage wisely can multiply your return and speed your progress towards your goal of lifetime cash flow. 00;13;00;10 - 00;13;29;05 Leverage risks. Generally, when you hear about investors running into trouble and losing properties to foreclosures, it's because they were overleveraged. Obviously, no leverage would mean that they owed nobody anything and that they would own those homes. It may have been too aggressive in borrowing, or they may have failed to plan for possible vacancy losses or rent decreases. Let's look at some of the factors that make too much leverage a risk. 00;13;29;07 - 00;13;52;14 Rent trends. What if there's a big apartment building spurt in your local area, and suddenly the inventory of nice rental units jumps up? There are plenty of places for renters to consider. So the landlords will have to become more competitive with rents. If your cash flow on a rental unit is too low, you could find yourself with negative cash flow very quickly. 00;13;52;16 - 00;14;17;16 Let's say you took on the three units in our third leverage example. We're still not talking about expenses, but your cash flow on those before costs and taxes is only $280 per month each. Let's say that your expenses were $140 per month each. Your net cash flow would then be $140 per month, each. Having to reduce rents, even on a small amount to compete. 00;14;17;17 - 00;14;39;17 Could take away most, if not all, your positive cash flow. And that's not taking to account vacancy periods when you're getting no rent at all, and trying to compete to get a new tenant at the new reduced rent levels. In this situation, you could easily find yourself with negative cash flow, increased costs. Taxes can and do go up. 00;14;39;21 - 00;15;06;17 Repairs happen. Utility bills increase. There are a number of expenses that will increase at any time. While a healthy market may allow you to pass those costs onto your tenant as increased rents. And often does leases keep that from happening right away. A sick market would cause lower cash flow with increased expenses, because you usually can't ask for rent increases in a highly competitive rental market. 00;15;06;19 - 00;15;28;11 Vacancy and credit losses whenever a unit is vacant. Cash flow is zero. People move and you try to be on top of the situation and have a new tenant lined up to move in right after you clean and potentially rehab the place. However, sometimes tenants don't stay through their lease or they fall in hard times and do not make their rent payments on time. 00;15;28;13 - 00;15;53;00 The more you're leveraged, the more this can hurt you. So be aware. Love the numbers, not the house. You'll see that we keep bumping into this advice. You're buying the numbers, though. They look very much like a house. Falling in love with a home may work for your personal residence, but it can be financial suicide when purchasing a rental home. 00;15;53;02 - 00;16;12;03 We're going to give you a whole lot of instruction in the numbers of rental property investment, using our material and mentorship. You're much less likely to end up in leverage trouble due to the normal ups and downs of rental property ownership. While leverage is something you'll enjoy to grow your business. You'll use it only when the numbers work. 00;16;12;06 - 00;16;39;29 Leverage is nothing to fear. It's something to embrace. You should embrace it as a tool to achieve your real estate investing goals. This book and our guidance will provide you with the knowledge and ability to use, leverage wisely, and stay out of trouble due to the normal gyrations of your market. Action steps. Get out some paper and a calculator and do some of your own leverage calculations. 00;16;40;03 - 00;17;03;19 You really want to see this for yourself. Try to get real world with them. Look in the paper. Look online and find single family homes for rent in your area. Use the rents they're asking for in your calculations. Take a stab at with the homey of cost the owner or landlord using comparable listing prices in the area. They don't have to be accurate. 00;17;03;19 - 00;17;33;04 It's just a matter of example and practice. Follow the examples that we just did. Do the first one with a cash purchase. All cash, no leverage. Then do another one with 50% down. That's 50% cash and 50% leverage. Then do another one with 33% down and 67% leverage. And then I encourage you to keep going and try one with 25% down and then 20% down. 00;17;33;07 - 00;17;54;27 Or you can pick your own numbers. Have some fun with it. This is practice and this is what's going to sharpen your ax for when you get out there in the real world. Don't get discouraged if your cash flow numbers are low because you're not working with actual purchase prices. We're going to give you the information and tools to make bargain deals, so you spend only the minimum you need to pay to get the numbers that you want. 00;17;55;00 - 00;18;18;22 Notice how your return on investment changes as you change your down payment. What's next? In the next chapter, we'll talk about the importance of credit, how credit scoring works, and how to improve your scores if they're less than stellar. Excellent credit over the long haul will allow you to borrow money at a much lower cost, raising your profits and cash flow.