Financial leverage is a very powerful tool. Much like the Egyptians moved massive stones using a only a fulcrum and lever to build the pyramids, financial leverage allows investors to make purchases larger than their capital invested. We discussed this idea in a previous post, regarding how this inherently makes real estate appealing compared to other asset classes.
Using “OPM” (Other People’s Money) is not a new concept but understanding how to best utilize leverage can be difficult to determine. There are three types of leverage: favorable (positive), neutral, and unfavorable (negative). For purposes of brevity, we’ll focus on favorable leverage since the other two are rarely used in investing. Favorable leverage means that the internal rate of return exceeds the amount of debt service on a property. For example, if your NOI on a property was $200,000, you would want to make sure that your annual debt service was below this figure in order to realize positive cashflows.
Yet like anything, too much of one thing is not always good for you. Leverage too much and you run the risk of future negative cashflows resulting in potential default. Leverage too little and you limit the amount of diversification in your portfolio and could also potentially put yourself in a position of default by putting all of your eggs in one basket.
When doing financial analysis on a property, it’s important to determine what the optimum loan-to-value (LTV) ratio is that will produce the greatest returns. Additionally, you can solve for an LTV dependent upon your target return rate. Talk with an investment professional that can help guide you through the process so that you optimize your investment and start building your financial pyramids one building at a time.