Hang around successful investors for any length of time and you are likely to hear them talking about leverage. You might be familiar with leverage as a principle of physics, but do you know what it is in an investment scenario? Leverage is investing’s secret sauce. It is what makes financing investments so irresistible.
Going strictly by the book, leverage in an investment scenario refers to using debt or borrowed money to fund a new investment. Excess leverage shares a substantial portion of the blame for the infamous 1929 stock market crash. Investors were borrowing too much money and not making enough to cover their loans.
At any rate, regulations put in place following the 1929 crash have tempered leveraging. Leverage looks a lot different today. One area in which it remains quite popular is real estate investing.
Borrowing to Buy
Imagine someone brand new to real estate investing. How will that investor purchase his first property? Maybe he has enough cash from a family inheritance to pay for the property up front. Perhaps he will combine his own limited resources with a bank loan. He might even go to a hard money lender for help.
The point is this: the investor is borrowing money to buy. He is taking advantage of leverage. This would make sense if he did not have enough cash on hand to cover the entire cost of the property. But it turns out that even investors with millions of dollars in the bank still finance acquisitions with hard money and bank loans. They still borrow to buy. But why?
Leverage Preserves Cash
One of the primary reasons for financing new acquisitions is preserving cash. Investors need cash to do other things, like pay for maintenance and repairs. They need cash to pay their employees and property managers. Tying up too much cash in new acquisitions just makes it more difficult for an investor to pay his bills.
Leverage, which is to say borrowing money, preserves cash for other needs. But that is not the half of it. Leverage also offers the opportunity to obtain a new property without having to lay out a lot of money. An investor only needs to throw in a small amount of his own money while the lender makes up the rest.
Spending a Little to Make a Lot
If this still doesn’t make sense to you, consider that leverage means spending a little to make a lot. Let us look at a real-world example from Actium Partners based in Salt Lake City, Utah. One of the firm’s past deals involved funding the acquisition of a multi-family apartment complex.
The investor came to Actium looking for a short-term hard money loan to complete the acquisition. Actium put up the majority of the funding; the investor put up the remaining amount. The deal was done, and the investor took possession of a property that immediately started generating rental income.
Meanwhile, he also arranged a conventional loan to pay off what he borrowed from Actium. Monthly rental income covered his monthly loan payments, all his expenses, and allowed him to get his down payment out of the property. He even made some profit.
Recovering his down payment allowed him to put that money into a new property. For all intents and purposes, he could continue repeating the cycle endlessly. As each loan is paid off, the property attached to it represents pure profit. In this way, leverage helps the investor earn a lot but only spend a little. That is the magic of leverage as a way to fund investments.