How Leverage Magnifies Returns
The term leverage means that you use a relatively small amount of cash to acquire or control a property.
Let’s say, for instance, you plan to buy a $200,000 rental property that produces a net operating income (NOI) of $20,000 a year. If you finance this unit with $20,000 down and borrow $180,000 (a loan-to-value ratio of 90 percent), you have highly leveraged your purchase.
Think of it this way. Though you put up only 10 percent of the purchase price, you virtually own and control a property. Whereas if you paid $200,000 cash for the property, you would not have used any leverage (i.e., other people’s money).
Okay, but here’s how differing amounts of leverage can magnify your cash-on-cash returns. We’ll consider the following four examples and calculate rates of return based on alternative down payments of $200,000 (an all-cash purchase), $100,000, $50,000, and $20,000. We’ll assume the financing at 8 percent for 30 years, or $7.34 a month for each $1,000 you borrow.
Example 1: $200,000 all-cash purchase
ROI (return on investment) = Income (NOI) / Cash investment
= $20,000 / $200,000
= 10%
Example 2: $100,000 down payment with $100,000 financed. Yearly mortgage payment equals $8,808 (100 x $7.34 x 12). Cash flow equals $11,192 ($20,000 NOI less $8,808).
ROI = $11,192 / $100,000 = 11.2%
Example 3: $50,000 down payment with $150,000 financed. Yearly mortgage payments equal $13,212 (150 x $7.34 x 12). Cash flow equals $6,788 ($20,000 NOI less $13,212).
ROI = $6,788 / $50,000 = 13.6%
Example 4: $20,000 down payment with $180,000 financed. Yearly mortgage payments equal $15,854 (180 x $7.34 x 12). Cash flow equals $4,146 ($20,000 NOI less $15,854).
ROI = $4,141 / $20,000 = 20.7%
As you can see with the figures in these examples, the highly leveraged (90 percent loan-to-value ratio) purchase yields a cash-on-cash rate of return double that of a cash purchase. In other words, the higher the leverage (the more other people’s money you use) the greater your rate of return.
