INVESTORS’ CORNER: Are You Using Positive Leverage?

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Use of leverage (debt) is an integral strategy for many real estate investors. But in my experience, misuse of leverage is the #1 reason investors lose money.  I have some negative cash flow “scars” to prove this from my own deals!

Investing using debt should be treated like carrying a loaded gun.  When my dad took me bird hunting as a little boy, he wisely taught me that a gun used carefully can provide you a meal.  But a gun used carelessly can be your worst nightmare.

Debt leverage is the same. It can be a great tool or your worst financial nightmare.

So, how do you treat leverage carefully? To start, make sure it’s positive leverage. This means your leverage is helping and not hurting your deal.

What Is Positive Leverage?

Positive leverage occurs when your investment property produces more income than the cost of your financing.  Put another way, it looks like this:

Positive Leverage = Cap Rate > Financing Cost

A cap rate basically tells you how good a property is at producing rental income. It’s the ratio of net operating income (before debt payments) to your total investment.

For example, here is a chart that shows the cap rate for a rental property:

The financing cost in my analysis measures the total financing payment that comes out of your pocket. So, the financing cost in my case includes both principal and interest payments.

Why Positive Leverage Is Important

Using debt is like renting money.  The lender lets you use the money for a period and then you have to give it back. During the time you keep the money, you pay “rent” to the lender (i.e. interest).

With positive leverage, you’re making a profit on that rented money.  Your return on investment increases because your debt contributes to the bottom line.

But with negative leverage, you’re making a loss on that rented money. Your return on investment decreases because your debt subtracts from the bottom line.

So, the name of the real estate leverage game is to use that rented money safely and profitably.

Chad Carson is a member of Metrolina REIA (metrolinareia.org), which provides education, networking, and networking for real estate investing in the Charlotte region.  Chad also writes about real estate, money, and life at coachcarson.com.