Financial leverage is the use of borrowed funds to increase potential returns. In the right hands, leverage can be a real wealth multiplier. For those who lack expertise or invest in risky assets, financial leverage can be a loss multiplier.
Let’s take a deeper dive into the world of financial leverage to better understand when it should and shouldn’t be used.
Financial Leverage and Loan-To-Value
With real estate, the leverage one uses to purchase a property is typically expressed as a ratio. It’s the amount of loan one takes divided by the value or sales price of the property. That ratio is called loan-to-value and is often abbreviated as LTV.
So if you purchased a ten million dollar property by putting down $2.5 million dollars and secured a loan for $7.5 million then your LTV would be 75%
$7.5 million / $10 million = 75% Loan-to-Value
Similarly, if you borrowed $5 million then LTV would be 50%. If you borrowed $6.5 million it would be 65%.
The equity you put down belongs to you while the remaining debt belongs to the bank. By using other people’s money, you are able to gain a larger property than what you could secure on your own.
Your equity should increase and the debt to the bank will decrease as you pay down the loan. Also, if you can maximize operations, then you can grow net operating income. Doing so increases the value of the property which increases your equity and shrinks LTV.
The bank may start out as the largest investor in the property, but you gain full control of its operations and its beneficial tax depreciation. As long as you service the debt, the leftover capital you generate is yours to do with as you please.
Financial Leverage For Enhanced Returns in Real Estate
The primary benefit of financial leverage is enhanced earnings. There are some real estate tax benefits available to those who use leverage as well. But I want to focus on the enhanced returns.
To understand how leverage increases returns, let me illustrate with an example. Pretend you purchased a $10 million apartment complex that over time has appreciated to $15 million.
To see how leverage enhances your return, let’s evaluate three scenarios.
In the first, you own the property free and clear from debt (no leverage) paying all cash. For the second scenario, you put 50% or $5 million down and financed $5 million for a 50% LTV. In the last scenario, you put $2 million down and financed $8 million for an 80% LTV. In all three scenarios, the property went from $10 million in value to $15 million, yielding $5 million in appreciation.
Let’s see how your returns vary depending on how much leverage you used:
Scenario #1: $10 million property purchased for all cash without any leverage.
$5 million (appreciation) / $10 million (equity) = 50% return on equity
Scenario #2: $10 million property purchased at 50% LTV
$5 million (appreciation) / $5 million (equity) = 100% return on equity
Scenario #3: $10 million property purchased at 80% LTV
$5 million (appreciation) / $2 million (equity) = 250% return on equity
In all three scenarios, you made money. However, the use of financial leverage magnified the returns as much as five-fold. Leverage can be a real wealth accelerator so it’s easy to understand why people use it.
Risk Management and The Rules for Using Financial Leverage
In the wrong hands, using the wrong strategies, leverage can cut the other way. It can also accelerate losses. The above equations work in the opposite direction. Imagine buying an asset that goes down in value. Those losses are magnified if you use financial leverage.
Does that mean you shouldn’t use leverage?
I would argue no. After all, understanding how to take advantage of financial leverage, is one of the greatest wealth multipliers available to investors. But the key is understanding when and how to use it correctly. To do that, you should understand some financial leverage rules.
#1 Only Use Financial Leverage When Returns Exceed Costs
There is a cost to borrowed money. Not only do you have to pay it back, but you have to pay it back with interest. So if the expected return on investment doesn’t exceed the cost of leverage then it makes no sense to deploy financial leverage. If a leveraged asset won’t provide positive cash flow after expenses then don’t use leverage.
#2 Avoid Becoming Over-Leveraged
It can be tempting to want to maximize financial leverage given that it magnifies returns. However, you don’t want to fall for that trap.
Use leverage to your benefit, but also leave room for the inevitable ups and downs that come with even the best investments. Survivability in a financial downturn can become a real issue for those who are over-leveraged as they’ve left little room for error.
#3 Don’t Mix Financial Leverage With Volatility
Just as drinking and driving don’t mix, neither should financial leverage and volatility. Whether that volatility comes in the form of price fluctuations or the income stream that pays for the debt, you should avoid using leverage where there is volatility.
As important as this rule is, far too many people ignore it. Whether it’s margin loans, futures contracts, options trading, foreign exchange trades, inverse and leveraged ETFs, or a whole host of other highly volatile asset classes, people gravitate to them like moths to a flame. Those investments are some of the riskiest out there because they combine leverage with volatility.
I’m not saying that people can’t make money in those investments, but losing money is the more common outcome. More often than not, the mixing of volatility with leverage is like playing with fire.
Don’t forget this rule and only leverage non-volatile assets.
Skipping Volatility with Multifamily Real Estate
Politics, weather, economic news, and other factors like supply and demand drive market volatility. Sex scandals, supply-chain disruptions, and changing consumer sentiment can all lead to precipitous declines. It’s the nature of the beast. The market is fickle and goes up and down without much hope that you, or anyone else, can predict what it will do in the short and intermediate terms.
That doesn’t mean that the market isn’t worthy of investment, but it does mean that you shouldn’t try to time it nor should you attempt to deploy leverage when investing in it. It’s simply too risky.
Multifamily real estate is different. It’s driven by population dynamics and not economic ones. It doesn’t fluctuate like a candle in the wind. Instead, it stands firmly in both good and bad economic times. After all, an investment in apartments is an investment in the basic need for shelter. And people have always and will always need a roof over their heads regardless of what the economy is doing.
Countless research has shown that the volatility of multifamily real estate is low. In fact, it approximates the volatility of stable government bonds. It’s been between three and four times less volatile than the stock market for decades.
Additionally, research done by the National Multifamily Housing Council (NMHC) shows that over a thirty-year period, multifamily real estate has had the lowest volatility (standard deviation) than the other commercial real estate asset classes (industrial, office, retail).
There is a large body of evidence that shows the lower-volatility nature of multifamily real estate lends itself well to the use of financial leverage.
#4 Financial Leverage is More Attractive in Inflationary Times
The default setting of our economy is inflation. And typically the consumer price index (CPI) runs around 3% per year. Currently, inflation is out of control hitting a 40-year high. Assuming you’re following the other financial leverage rules, that’s good for those of us who use leverage to grow wealth.
Inflation weakens the value of a dollar, but debt service is typically fixed. So you get to pay that fixed debt with weaker inflationary dollars going forward. But the opposite is true in deflationary times.
During times of deflation, a wide range of assets typically decline in value. In general, this isn’t the best time to deploy financial leverage. With that said, deflation lends itself to investment opportunities. Some say that these are the times when investments are on sale.
So if you decide to deploy leverage, be sure to follow the other rules and buy something that is stable, provides ample cash flow after paying all expenses, and doesn’t over-leverage your position. If you do that, in the long-term you should be able to weather any economic downturn.
#5 Have an Exit Strategy for Cutting Leverage if Necessary
Financial leverage is great, but it’s not useful in every situation. For that reason, it’s important to have a clearly defined action plan for when you’ll ditch that leverage. Financial leverage is nothing more than a tool. It should be used when it makes sense and abandoned when it doesn’t.
You need to know the difference or invest with someone that does.
Obey The Financial Leverage Rules to Maximize Investment Returns
Financial leverage can be an important wealth multiplier you can access to achieve your financial goals. However, because it cuts both ways, there is a right way to use it and a wrong way.
The above rules are important to remember if you want to increase the odds of leverage working in your favor. Multifamily real estate is uniquely well-positioned to profit from financial leverage.
It’s a low volatility asset class that can provide instant cash flow in excess of the costs of leverage. There are multiple sources of debt financing available to the investor allowing for competitive terms.
It’s a proven asset class that has held up well in the face of recessions / deflationary times. In fact, multifamily real estate has outperformed many asset classes during the COVID-19 pandemic.
Over several decades multifamily apartments have performed well in both good times and bad. Inflation has historically been generous to apartment investors and that is certainly the case now.
If you haven’t invested in apartments before or if you want to learn how you can accomplish that without having to become a landlord then now is the time to act. Take a minute and schedule an introductory call to learn more about the 37th Parallel advantage.