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"The more I know, the more I know I don't know too much."
There is a lot of information out there about investing in real estate. Some of it is interesting and some of it is not. Some of it is beneficial and informative, while some of it is purely comical. Much of the worthwhile knowledge, I feel, is many times presented in an unnecessarily complicated and esoteric way. So, I started this page hoping to outline some real estate concepts in a way that is more easily understood. If you learn something, let me know. If I get something wrong, please let me know... it's the only way I'll learn. Thanks for visiting!
Leverage
BTIRRE = BTIRRP+ (BTIRRP - BTIRRD) * (D/E)
Easy enough? Maybe. Or does it bring back the sweaty palms and dry mouth reminiscent of high school algebra? Don't worry, understanding this equation is not necessary for understanding the principle of leverage.
Current savings account rates are around 5% for larger balances. That means that you'd earn $500 annually on a $10,000 balance. But, what if you were able to borrow $8,000 of the $10,000 and only pay 3%, or about $240 a year in interest?
That means you'd deposit the $8,000 from the loan and $2,000 of your own money to get you to the $10,000 balance, right? You'd earn $500 a year, but you'd pay $240 in interest, leaving only $260 for your pocket. But remember, you only put in $2,000 of your own money. That means you actually earned a whopping 13%! ($260 / $2,000)
In other words, if you actually had $10,000 and you chose to only invest $2,000 and borrow the additional $8,000, you'd actually increase your return. Eventually you'd probably say to yourself, "Self, why don't I use all of my $10,000? I could borrow $40,000 and invest $2,000 in five separate accounts. Then I'd make $1,300 ($260 * 5) on my $10,000."
That's leverage, plain and simple.
Something to keep in mind, the cost of the debt, or the interest rate, has to be less than the investment return. Or, in this case, the loan has to have an interest rate of less than 5%. Also, this benefit seldom applies to savings accounts and personal loans. Typically, savings accounts earn less than the cost of such debt. Real estate, on the other hand is riskier and therefore should theoretically earn a higher rate of return.
And what about that equation above? Well, that's just a fancy way of showing the benefits of leverage. (BTIRR just means "Before Tax Internal Rate of Return")
BTIRRE = BTIRRP+ (BTIRRP - BTIRRD) * (D/E)
or,
Benefit of leverage = 5% + (5% - 3%) * ($8,000 / $2,000)
then,
Benefit of leverage = 5% + (2% * 4)
and, finally,
Benefit of leverage = 13%
Easy enough.
