Step 5: Assessing Effect of Financial Leverage
If you know a property's overall rate of return, you can also estimate whether borrowing money to fund your investment (also known as using financial leverage) enhances your profits.
Here's the simple arithmetic trick you use to determine whether borrowing makes sense: If the property's overall rate of return (as calculated in step 4) exceeds the annual percentage rate you pay on the money you borrow, you enhance your return by borrowing.
If you borrow money at 3% interest, for example, and reinvest the money in property that earns 8% (maybe this is a property with a 5% cap rate and you're assuming a 3% inflation rate), you enhance your profits. In fact, you actually make out like a bandit. If through the magic of leverage, for example, you could invest in $10 million of real estate using only borrowed money, a 5% difference means you're making half a million dollars a year in profits...and you're probably feeling a financial genius.
You need to be really careful about using financial leverage though. In the recent financial meltdown, clearly many (and maybe even most) small real estate investors didn't understand that leverage works both ways. The grinding arithmetic power of leverage not only amplifies profitability, it can also amplify losses.
Suppose someone invests in a property that delivers a 2% cap rate and then unfortunately sees 5% deflation in the property value. (This is what started happening during the great recession for many investors.) In this case, the property's overall rate of returns equals minus 3% (because 2% minus 5% equals minus 3%.) If the investor then borrows money at 8% to invest in a train wreck like this, the investor is actually losing 11% annually (because minus 3% minus another 8% equals minus 11%.)
The former real estate "genius" with the $10 million of real estate who only recently was making half a million a year is now losing $1,100,000 a year and on the way to short sales, foreclosures and possibly bankruptcy.
I don't share these ugly calculations to put you off from investing in short sale properties-though you absolutely do need to be careful. Rather I share the calculations to explain further why this unusual real estate investment opportunity exists. And I share them to underscore how important it is to be thoughtful and careful as you develop your cap rates, come up with appreciation rates, and look at how borrowing affects your returns.
Next Section: Short Sale Discounts, Cap Rates and Your Investing
Additional Information for Shortsale Investors
If you want additional information about how tax laws work for a short sale investment or for an individual running a business based on short sale investing, you may also be interested in one of my downloadable e-books shown below:
Tax laws provide active real estate investors with giant tax planning loopholes. A little upfront planning on your part could save you thousands a year...Read More
One of the most powerful tactics for saving small business taxes is maximizing your deductions. You can literally save thousands in taxes each year.Read More
Using an S corp for your real estate investing? To maximize savings, you need to minimize the salary paid to shareholders. But this decision is tricky.Read More