What is the return on the ASSET, (watch out for leverage!)

[Robert Plumpe]

Hey all:

I was just watching an evaluation of a duplex on the YouTube!  The house is a duplex in Denver with a purchase price of $385K.  Each unit is a 1 bedroom/1 bath.  HOWEVER, the bottom unit is a "garden" apartment, and partially underground (brings reduced rent).

The presenter ran the numbers, and it appears that the property comes up with positive cash flow of about $700/month.   The purchase price was about $385k and the downpayment was about $15k.

The monthly expense for repairs/capital improvements was $50 a month, which the presenter thought was a bit low...but the units were recently redone and in EXCELLENT shape.  I think that is TREMENDOUSLY low as that might not even cover the roof/furnace/ac depreciation...but we'll go with those numbers just for discussion.

There was also no allowance for vacancies either...but the presenter says that Denver is a hot market, and rentals usually go quick.  I'll take him at his word, but I think a small allowance would be more appropriate.

WHAT REALLY STRUCK ME was that the purchase price (value of the asset) was $385k.  The owner is going to be clearing $8,400 a year under OPTIMISTIC conditions.

He is getting about 2.1% ROA ($8,400/$385,000) per year!  The use of leverage here is simply incredible.  I don't think he is getting anywhere near an adequate return and it is a terrible deal.

Why is that?  He is using close to $400k in assets to get  a return of $8k, 2% a year.  If something goes wrong, ANYTHING goes wrong...he is going to be underwater quick fast & in a hurry.

What happens if the economy goes south and real estate goes down 20%?   His investment would be then worth about $75k less, which is NINE YEARS OF PROFITS.

What happens if the roof needs to be replaced in 4-5 years?  That could wipe out YEARS of profits...

What happens if interest rates go up the next 3-5 years?  If the cost of a mortgage goes from 4% to 6% or even 7%, the value of that property is going to go down TREMENDOUSLY.

Using that amount of leverage (about 33:1) everything HAS to go according to plan for YEARS, or even DECADES.

So many people are making the mistake of not contemplating the amount of leverage that is in play.  That is one the things that lead to great crash of 08, and I see signs everywhere that is being repeated.

If you use enough leverage, almost ANY deal can look good.  I think that is a mistake.

Anybody else contemplate the amount of leverage they are using when figuring out a deal?