What is leverage in real estate? – In layman’s terms

I dare you to try pulling out a nail with your bare hands!

Leverage isn’t as complicated as it seems even where leverage in real estate is concerned.

I built a fence last summer and used leverage the entire time to pull out nails that I hammered in sideways!

A hammer for example uses leverage to remove nails.
The long handle and shape of the claw let me use just a little effort to remove a stubborn nail!

In general, leverage provides you a better way to accomplish something with less work, less time, less money, and sometimes less emotional and mental exertion.

The idea behind leverage is using one or many things or people to aid you in simplifying your task at hand. The outcome is that you can accomplish much more when leveraging than you ever could on your own.

Let’s take a quick look at a business project.

Your boss assigns you to be responsible for putting together a comprehensive proposal for a building contract due the end of next week! Yikes!

What do you do? Do it all yourself? Do you have all the required skills to make this successful? If you do have the skills, do you have the time to do it while maintaining the level of quality needed?

As much as we’d like to have Superman-like abilities…I know I do… the truth is we are only human and in order to make our lives simpler we need systems and teams!

In the real world, organizations and individuals seek to utilize leverage in everything they do! So should you!

With that in mind, your project will likely go as follows.

1. You network to find and organize people who possess necessary skills.
2. You assign deadlines to teammates.
3. Your team create budgets.
4. You conduct meetings and collaborations with your team.
5. You recruit auxiliary personnel for support in other menial tasks.
6. After you have done your job of organizing the team. The team then gets to work assuring the highest quality and most timely completion of the proposal.

In other words, you “Leveraged” other people’s time, talents, and resources to achieve something you could not have done on your own.

If we were to quantify this project maybe we could say you put in roughly 20% of your time, energy, and talents while the rest of the team covered the other 80% thus freeing you to attend to other important things like family, recreation, hobbies etc.

This is how things get done! And this is exactly how building a powerful real estate retirement portfolio is done too!

So why don’t people leverage their money?

I would argue that people just don’t know how!

The principle of leverage is essential in regards to money and wealth creation. Most of us are mired in the old paradigm of exchanging time for money like an employee or self employed professional.

We get paid when we work and we don’t get paid when we don’t. That’s the problem we all face as we aren’t able to be in two different places at once. BUT, many truly wealthy individuals know that real wealth is when your money does the work for you and serves you instead of you laboring for it!

Leverage is a tool of liberation!

Though we may not know how the principle of leverage works with money, we use leverage everyday.

Heck you are leveraging technology right now to read this! You may not have used that word to describe what you are doing but it certainly applies.

What if you could put $20,000 into something and get a $300, $400, 0r $500 monthly return or profit all while maintaining the original 20k? How does $3,600, $4,800, or $6,000 yearly return on that initial 20k sound? Percentages look like this: 18%, 24%, and 30%!!!

That is the power of leverage in real estate!

So what does leverage mean in real estate?

Leveraging real estate means you provide 20-30 percent of the total purchase price or a 2:8 ratio in order to control a piece of real estate worth much more than your initial investment all the while it produces high returns.

For example, you can control a $100,000 property with only $20,000 of your own money. This controlling position also affords you 100% of the benefits that the asset produces.

Leverage, when used in real estate, is the most common and effective method of creating and growing wealth. It also affords an opportunity for nearly everyone to participate!

How does it work?

Let’s say you are looking for a personal residence and you have saved roughly $10,000 to put towards a down payment.

Current lending guidelines say that if you will be living in the home otherwise called “owner occupied” means you can pay less than 20% of the purchase price in order to secure a mortgage or loan for the remaining balance.

With these guidelines in place lets say you find a house with a purchase price of $100,000. You put $10,000 towards the down payment which is 10%. The bank loans you the remaining $90,000.

You move in and live your life! You are now considered the legal owner or controller of that house which is worth $100,000! All you had to do was come up with the 10% up front and it’s yours.

In number speak, you control an asset worth $100,000  with only $10,000 or one-tenth of the total price. If the property goes up in value you get the growth on the entire $100,000 instead of just the money you put into it!

What if you use leverage as an investor?

 

There are many different scenarios that can illustrate this when you are an investor so we’ll keep it simple and uncomplicated. You can refer to Real Estate ROI Calculations for a more detailed description on how to determine you returns.

Let’s say you have $20,000 saved for a down payment but this time the guidelines are different because you are not going to live in the property. Instead you are going to rent the property to someone in hopes of making a monthly profit.

As an investor you will be required to pay 20% or more as a down payment before the lender will finance or loan you the remainder of the balance.

You have done your homework and have been working with a great agent who helps find you a property with a purchase price set exactly at $100,000.

As the deal progresses you pay your $20,000 and secure a mortgage for $80,000. This leaves you with monthly expenses at $222.22 mortgage not including interest, $115 insurance, and another $120 in taxes for a total of $457.22 per month.

You are able to rent the property for $900/month which results in $442.78 in profits each month and $5,313.36 per year! Keeping it simple this would equate to roughly 26.5% cash-on-cash rate of return on your original $20,000 not including tax deductions etc.

Now let’s assume that the property goes up in value a year later to $115,000. This $15,000 increase along with your original $20,000 can be taken out of the property and invested into another one.

Now you have two properties providing monthly income and potential equity growth instead of just one. You did all this while using a small portion of your own cash! You can repeat this cycle of wealth creation and growth as many times as you want as long as your tenant’s rent covers your mortgage and a little more!

Reap the Leverage Advantages

When you can utilize  other people’s money or commonly referred to as OPM while leveraging; your capital investment of 10% in a property can generate income, full property ownership, appreciation of equity, and tax deductions.

The lender, who lent you 90% to purchase the property, only benefits by being repaid their capital in the form of  interest and principle payments. As long as you pay your mortgage obligation to the bank via the monthly rent check, you enjoy all the liberating perks of leverage!

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What is leverage in real estate? – In layman’s terms By Joe Nielsen