The Zen of Leverage
We had just taken off from the Portland airport, and I was getting comfortable in my seat. Well that’s if you call getting comfortable negotiating with your neighbor’s elbow.
I leaned down to get my computer out of my bag. I needed to write my monthly client article and this month’s topic was going to be about investing using leverage. I grabbed my notebook computer and made sure it had a charge and then pulled down the tray table. I was ready to write.
I was interrupted by the neighbor next to me, who looking over my shoulder and noticed that I was writing about real estate investing. He started talking to me, and once he found out that I was a real estate broker he became very excited. He said that his stocks were performing well, but that he was 45 years old and felt that real estate might give him more growth potential. His father had done very well in real estate, but had neglected to teach him how to invest. Could I help him?
I looked at him, frustrated because I only had an hour to write my article. But as every salesman knows, you have to ‘strike while the iron is hot.’ He was asking for help and every deal I close means that I have more money to invest for my own retirement. I turned to him and said, ‘I would be happy to help you.’ I quickly summarized how in addition to buying low and selling high, there were at least four ways to making money in real estate:
- Cash flow,
- Depreciation shelter
- Debt reduction
I told him it was wise to review these concepts with a CPA who could confirm my explanations. I also told him about leverage. To him this was the most intriguing part of our conversation. He asked me, ‘How much leverage is good leverage?’
I responded in the usual noncommittal real estate manner, ‘Well it depends – .’ Then I explained the following:
Typically the higher the leverage, the lower the pretax cash flow because more cash is required to meet the mortgage payments than on a lower leveraged property. The higher leverage also results in the ability to acquire a more expensive property which achieves a higher level of depreciation (shelter).
This in turn decreases taxable income and creates a positive effect on after-tax cash flow (more shelter). With higher leverage and a more expensive property, the effect of appreciation is magnified as the size of the asset appreciating starts at a higher level than one acquired with the same down-payment in a lower leveraged property.
What does this mean?
This means that if you are conservative and have no leverage (in other words you put 100 percent down and borrow no money), you return more current cash flow but have less upside from appreciation and depreciation because you are purchasing a smaller investment. We have appended 3 examples to this article assuming the same million dollar down payment with:
- an all cash purchase
- 50 percent down
- 30 percent down
As you look at the numbers you can see that in the first scenario, you have a $391,808 present value of after tax cash flow received. In the second case you will notice a present value of cash of $536,694. In the third example you will notice an after tax present value of $727,036.
These three examples all assumed a 7 year investment horizon. Taxes were calculated on the basis of 41 percent federal and state income taxes, as well as 15 percent federal capital gains taxes (each state has their own capital gains tax percentage) with a depreciation recapture of 25 percent at time of sale.
Bear in mind that the risk factors change too. With 100 percent down you have no real risk. With 30 percent down you have more risk if your investment does not mature over the initial investment period — in this case 7 years. This is especially critical if you need to refinance at a potentially higher interest rate in order to hit the real estate cycle at the right time to maximize your sales price and returns.
Once we had reviewed this information, my seat neighbor asked me, ‘How much leverage do you recommend?’ I sighed deeply, but continued, ‘It depends on your age and cash requirements.’ If you are in the prime of your life (young and adventurous) and you don’t really need cash flow, you probably want to consider as much leverage as the banks will allow.
On the other hand if you are 80 years old and need consistent cash flow, you will most likely chose more money down, or less leverage. Since my neighbor was 45, I suggested higher leverage.
At that moment the flight attendant came on the intercom and asked us to fasten our seatbelts and put our tray tables in their properly upright positions. I powered-down my computer and put it away. I passed my business card to my neighbor and he gave me his card. He asked me to look him up when I got home because he was now ready to invest in real estate. I then leaned back in my seat and spent the next ten minutes on our approach to our destination meditating on the Zen of leverage.
Written by Clifford A. Hockley for www.RealtyTimescom. Copyright