A few posts back, we touched on the concept of “Leverage” and now let’s expand the conversation. By definition, it’s simply using borrowed money to increase your return (aka profits) in an investment property. It is a legitimate investment strategy, but is best applied to ‘good cash flow’ properties, which would appear to have a probable likelihood of future appreciation.
Consider the following investment, as a simple illustration:
I - WITH NO FINANCING
Property Purchase -- $200,000 (all cash investment)
Recent/Projected Market Growth – 5% per year
After Year 2 -- $220,000
ROI – 10% (on cash invested)
II - WITH 70% FINANCING
Purchase Price -- $200,000
Cash Investment -- $60,000
Recent/Projected Market Growth – 5% per year
After Year 2 -- $220,000
ROI – 33% (on cash invested)
This is a simplistic illustration and assumes the property is in a growth market,
which expects price appreciation – in this case 5% per year. It would not
be a realized gain, unless the property was infact sold after year 2. But you can see based on the market assumptions which are made, the potential to increase your return goes up significantly in the second scenario.
In the case of a flat market (no growth), the return would be the same (0) - but you would have $140,000 to put towards other properties. For the record in a declining market, the negative return would be less in the first scenario - but you would also have more cash at risk ($200,000 vs. $60,000).
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