Discover the Art of Leverage for Creating Wealth

A Comparison of Two Real Estate Investors

My love for writing doesn’t pay nearly as well as the cash flow and wealth creation I primarily enjoy in commercial real estate.

Because 98.3% of the articles on Medium seem to be about making money, I am committed to sharing a few things I’ve learned over the last thirty years of investing in real estate, stocks, bonds, mutual funds, and private companies.

Residential and commercial real estate can be lucrative investment opportunities for investors seeking to create cash flow and long-term wealth.

Leverage is debt. Leverage can be a powerful tool for investors interested in investing in real estate. Leverage involves borrowing money to invest in an asset, such as obtaining a residential or commercial property loan.

Using leverage, investors can increase their potential returns and grow their wealth over time. As we’ll see in the end, leverage can become a slippery slope leading to bankruptcy.

Two Investors and the Short-Term Analysis

To illustrate the impact of leverage, let's compare the returns of two investors — one who pays cash for a $1,000,000 property and one who borrows 80% of the purchase price from a lender at a 7% interest rate.

While the cash buyer would not have to pay interest, they would also miss out on the benefits of leverage. On the other hand, the leveraged buyer would have access to increased earning potential despite paying interest on the loan.

Assuming an interest rate of 7%, the leveraged buyer makes a down payment of $200,000 and borrows the remaining $800,000. Suppose the property generates $100,000 in rental income and incurs $60,000 in expenses, resulting in a net operating income (NOI) of $40,000 in the first year.

After deducting the interest payment of $56,000, the leveraged buyer would be left with a net cash flow of -$16,000 for the year. This represents a cash-on-cash return of -8% ($16,000/$200,000).

Long-term Analysis

Let's compare the internal rate of return (IRR) over ten, twenty, and thirty years for both the cash buyer and the leveraged buyer. The IRR measures the profitability of an investment over a given period, accounting for the timing and amount of cash flows.

• Over ten years, assuming a 5% increase in property value each year, the cash buyer would earn an IRR of around 5% per year.
• On the other hand, the leveraged buyer would earn an IRR of approximately 10% per year.
• Over twenty years, assuming the same 5% annual increase in property value, the cash buyer would earn an IRR of around 5% per year, while the leveraged buyer would earn an IRR of approximately 12% per year.
• Over thirty years, assuming the same 5% annual increase in property value, the cash buyer would earn an IRR of around 5% per year, while the leveraged buyer would earn an IRR of approximately 13% per year.

Return Analysis — Internal Rate of Return (IRR)

As we can see, the impact of leverage on returns can vary greatly depending on the interest rate. At a higher interest rate of 7%, the leveraged buyer would experience negative cash flow in the first year, resulting in a lower cash-on-cash return.

However, even with the increased interest cost, the leveraged buyer would still earn a higher IRR over the long term, demonstrating the power of leverage in creating wealth through commercial real estate investments.

The interest rate is a crucial factor that can significantly affect the returns of a leveraged investment. By taking calculated risks and factoring in the long-term benefits of leveraging, investors can increase their potential wealth and build a strong portfolio of commercial real estate assets.

In summary, leveraging can be helpful for investors looking to maximize their returns in commercial real estate investments. However, it is crucial to carefully consider the risks and rewards of leverage before making any investment decisions.

The Flip Side of Leverage

While leverage can amplify returns and create wealth over the long term, it also carries inherent risks. One of the primary risks of leverage is increased exposure to financial losses.

When investors borrow money to invest in a property, they magnify gains and losses. Suppose the property experiences a value decline or a cash flow reduction. In that case, the investor will still be obligated to repay the debt, which could result in negative cash flow, default, or foreclosure.

Additionally, leverage increases the overall cost of investing, as the investor is required to pay interest on the loan, which reduces the net cash flow and overall profitability of the investment. If the interest rate rises, this will further increase the borrowing costs and reduce the returns.

Another leverage risk is the potential impact on the investor's credit rating and ability to borrow. If an investor cannot make payments on their loan or defaults on their debt, this could negatively impact their credit score and make it more difficult to secure future financing. This can limit investors' ability to take advantage of future investment opportunities.

Wisdom Is Priceless

In conclusion, investing in commercial real estate is one example of how investors deploy leverage or debt. The burden of debt is not to be taken lightly. It takes years of experience to build wisdom.

My business partner and I routinely look for distressed commercial real estate opportunities. We use our cash and leverage. We also worked to graduate from single-family properties to multifamily and commercial real estate for many decades.

Wisdom knows when to use leverage and when not.

The bottom line is that leverage can greatly accelerate wealth creation over the long run.

Creating wealth is a process, not an event.

If you're starting with your investment journey, study those who are wiser and wealthier, find mentors, spend less than you make every month, save, and invest the difference.

Enjoy the journey.

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