In this video I demonstrate a real life example of how leverage creates high returns.
Hi, this is Devin Elder. Today I want to talk about leverage for higher returns, specifically I’m talking about investing in real estate. I’ll use a simple example here. We’re going to talk about an apartment building that’s worth one million dollars. So, you could go out and by leverage I mean using bank financing, right? So, we’re going to get the bank to lend us 70, 75 or 80% of the value of that property, but I want to highlight two examples.
One is just using all cash. The other is using bank financing, which I’m calling leverage here. So in this example we’ve got a one million dollar building. If that building improves in value by 5%, so the building value goes up by 5%, that’s a $50,000 increase in value. So the increase is going to remain the same. The dollar amount’s going to remain the same in this example, right?
So we’ve got a $50,000 increase of 5% improvement in value on a property. Now I want to take a little detour here and talk about multifamily property or apartment complexes specifically. One of the reasons we love investing in them is because we can create this value. We’re not necessarily waiting for the market to improve. We can go in and do something called forced appreciation where we’re improving the net operating income and reducing expenses and we’re having a big impact on that property.
So a little side note there on why we like multifamily is that we have control over the, or we have more control over the profit and the value of that property versus in residential or single family just houses we’re kind of at the mercy of the market, so two different approaches there. One reason we like multifamily is to control the valuation of it.
So, we’ve got a one million dollar apartment building. It’s gone up 5% in value, that represents $50,000. If we bought this building cash or we owned it cash not using leverage, we have a 5% increase on our million dollar investment, right? Fifty thousand dollars. However, we’re not going in there and buying these cash. We’re using bank money, this could be four or 5% money. It’s basically almost free money.
The banks love to lend on collateralized assets, right? You’ve got land and a building. It’s not going to go to zero in value, so the banks like to lend on these type of assets. So what we do is we use the bank’s money for, let’s call it 80%. So we’ve got a loan which is leverage for $800,000, which means our equity in that property is not a million like the first example, our equity now is 200,000.
So we’ve got $200,000 of our own money in this deal, right? Or it could be our money combined with other investors’ money, but the point is the owners of this apartment building have $200,000. So what happens now if that’s our equity position and the value of the property goes up 5%? That same $50,000, right, in value creation, it goes up by 50,000. What our basis now or our equity position is not a million dollars anymore.
We’re leveraging the bank that makes money at almost free interest rates, right? Four or 5%, something in that neighborhood. Now our equity in the property is only 200, so if we see a $50,000 gain on 200, you can forget about your 5% increase here. Right? Because a $50,000 increase on 200K now becomes … Well, that wasn’t right. Now becomes 25%.
So by using leverage, other people’s money, the bank’s money, we’re taking our equity position and a $50,000 improvement, which is not a massive improvement. Five percent is not a massive crazy improvement, but it’s improvement on the overall asset value. What that does with our $200,000 we have in it, we’ve bumped it up by 25%. That’s really one of the magic tricks that you do in real estate and one of the reasons we love using the bank’s leverage, the bank’s financing, because we can have a smaller out-of-pocket expense, right?
We don’t have to have a million dollars cash necessarily to go do that, but when we see that increase, that increase is on the entire asset value, but we’ve only got $200,000 in this deal so we’re realizing a 25% return on our equity position that we have and that’s very powerful. It’s the reason that wealth can be created relatively rapidly in real estate and specifically in the multifamily space.
I wanted to explain that for some folks because some people have a knee jerk fear against debt in general and in your personal life that’s valid, credit card debt, things like that that are not income-producing. That is a bad or negative, but on the business side debt that creates these kind of returns and is used safely and wisely and you’re not over-leveraged can yield massive results in a relatively short time. That’s one of the things that we love about doing real estate. I hope that’s helped you understand a little bit more about how we can use leverage to increase our returns.