It can be a simple concept to understand but difficult to grasp, leverage. Many real estate investors that understand leverage seek out a hard money using leverage or private money loan to maximize their return on investments and their bottom line. However, some beginning real estate investors need to understand the power and dangers of leverage.
Merriam-Webster’s dictionary includes two very different definitions. The first suggests strength: “power, effectiveness.” The other, on face value, has little to do with control: “the use of credit to enhance one’s speculative capacity.”
Lets look at an example of leverage in a real estate investment context. Consider a real estate investor who has $50,000 in cash. That investor could use that money to buy one home valued at $50,000. If that home could be quickly sold for $55,000, the investor would have gained $5,000. This equates to a 10% return on investment. If that same investor used the original $50,000 in cash to put a $10,000 down payment on 5 different homes valued at $50,000 each, got hard money using leverage and financed the rest of the money, and then sold all 5 homes for $55,000 each, the investor’s profit would have been $25,000 – an astounding 50% return on investment. The real estate investor also put an extra $20,000 in his pocket over the same period of time. You can see the power of leverage. However, there are two conditions necessary for financial leverage to actually become powerful. The first is that the borrower must be able to make his payments, or he risks repossession. The second is that the asset underlying the leverage holds its value. As leverage accentuates the profit when asset values rise, it decimates return when values fall.
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