The Power of Leverage

I talk about real estate investing with many people every day. If they are new, invariably they ask me, “How much money do I need?” So in this post, we’ll talk about that. If you Googled your way right to this page, you may want to check out the page on getting a mentor first.

We talk about investing in single family rental homes in the Dallas, Fort Worth, Denton area. We invest in homes that make financial sense to rent. Read about what kind of homes make good rentals. So, our discussion on how much money you are going to need is based on that framework.

Real-estate, especially the one that houses people, is one investment vehicle that banks are willing to lend money for, despite all that’s happened in recent years. They are a lot more careful about who they give money to, but nevertheless they still do. If you want to invest using other people’s money, single family rental homes is probably the best place to get started. So, if like we discuss in these blogs, you want to buy a rental home for about $100K, you certainly don’t need to buy it all cash.

So how much do you need? The answer is going to depend on where you are as an investor. Let’s assume you are a new investor with good credit and you do not own any single family rental homes. In that case, if you obtain a conventional loan, you are probably going to need about $30K to buy and start operating that $100K house. You may have to put 20% down to purchase and $10K for repairs and closing costs. If you have to leave 30K in every house, you may soon run into a ceiling on the number of houses you can invest in.

If you would like to have a portfolio of single family rental homes, then you need to find a way to keep more of your money and let other people fund your deals. There are some options. When you work with your mentor or agents who own and operate single family rental homes, they can introduce you to their bankers and mortgage brokers. They can instill some confidence in the lender, that you will know how to operate your property as you are working with someone they trust and respect. They can begin to believe that you are getting educated on this business model.

When you get small banks or other private lenders to fund your loan, you can get them to finance the purchase price, the closing costs and the rehab costs. Let’s say your purchase price is $90K and your closing costs are about $4K and it will take another $6K to fix the property. That’s a total of $100K. You can get the lender to finance this entire amount. Note that they are receiving as a collateral a property that’s worth only $90K (at the time of purchase). So they are taking a risk by lending you more than what it is worth. In return, they usually demand a higher interest rate. You can keep this loan till the property is fixed up and rented and then refinance into a lower rate, long term (15 or 30 year) mortgage with a conventional lender. This way you have not put any of your own money into the deal. Note that till the property is rented out, you will still incur utility costs, maintenance costs, taxes and marketing costs. But this is a small fraction of what it would have cost you otherwise with a conventional loan. This method will enable you to do several properties without depleting you liquid cash.

There’s cost to using other people’s money. When you purchase the property for cash and use your own cash to fix it up, you can think of your overall asset position to be largely the same. That is, you have converted some of your liquid assets into illiquid ones – but it’s still there. On the other hand, when you start using other people’s money, you will actually have true expenses (but you will keep more of your liquid cash). There’s a cost to preserving your liquidity. You will pay interest on the money borrowed, you will pay closing costs – probably twice, once to purchase and then to refinance into a long term mortgage. You are paying some interest on the closing costs and rehab costs as that’s included in the loan as well. These are true expenses – that is they do not go into your house. They don’t make your asset any better. So you have to think about that.

There are benefits to using other people’s money of course. You get to do more deals faster. You can also deduct several of these true costs like interest paid on mortgage loans as business expenses. The more you use other people’s money, the more you are going to know other people. The more they know you know how to use their money, the more money you can get. I see it as being more “economically active”.

Leverage will enable you to expand your business much more rapidly than you can do with your own cash. It’s powerful. Use it responsibly.