23. Leverage in Real Estate — How One Dollar Can Do the Work of Ten

A lever is one of the oldest tools known to man. You want to move a heavy stone which you could not budge with your bare hands. A lever applied in the right place will enable you to do the job for which otherwise several men would be required. Investment leverage works the same way. A dollar strategically placed can do the work of several dollars. An illustration of the operation of lev­erage follows.

Suppose that a syndicate acquires a property for $1,250,000. $250,000 is paid cash. The syndicate gives a mortgage for $1,000,000. Assume that the value of the building increases over a period of 5 years by 20%. It will then be worth $1,500,000. Such an increase in value is by no means far-fetched or unusual. During the last 5 years many properties increased far more than 20%.

At the time the syndicate acquired the property it did not have to raise $1,250,000. All it needed was $250,000 cash. If it were to sell the property for $1,500,000 it would make a $250,000 profit, or double its cash invest­ment of $250,000. Note that while the value of the prop-city went up only 20%, the profit on the investment was 100%. This is not bad, but it is only part of the story.

During the five years when the syndicate owned the property it made payments on the mortgage. Part of these payments were to defray interest. But each year part of the payment was applied to reduce the mortgage. This is another way of saying that part of this money was used to pay back the loan secured by the building. Assume now that during the 5 years the syndicate paid back $250,000 on the mortgage. Then, at the end of 5 years it owes only $750,000 on the mortgage. When the syndicate now sells for $1,500,000 it will get $750,000 cash above the mort­gage.

Now take another look at the dollar amount the syndicate invested and the dollars it got back on its investment. It invested $250,000 cash. Five years later its net worth had grown to $750,000 or 200%. This was accomplished although the building which the syndicate owned in­creased only 20% in value. If you had invested your money into anything else which would have increased in value by 20%, every dollar invested would have increased to $1.20 in value. In our example the value of the build­ing increased 20%. Yet every dollar invested is now worth $3.00. In one case the increase in value for each dollar invested is 20 cents. In the case of the building the in­crease amounts to $2.00. Your money invested in real estate grew 10 times as fast as it might have otherwise.

Are You Ready To Move Onto The Next Lesson? Click Here...