Is leverage still a good thing?

[Matt Lane]

I am struggling with determining how much money to put down on any specific property. I have always heard it’s best to use other peoples money but with higher interest rates would it not be smarter to put a bigger down payment down to have a smaller mortgage and a smaller payment?

[Dan H.]

There is a difference between leverage and over extended.  For best return, you want to use as much leverage as you can, but you want to avoid being over extended.  I define over extended that a scenario such as the Great Recession (GR) that had many markets suffer large RE price declines and increased vacancy/lower rent would cause you to either sell or default.  It is my belief that by my definition many RE investors are over extended, especially less experienced RE investors.  You do not want to be over extended.  You do not want to be forced to sell at a market low.

Why does leverage increase ROI? It is because the invested amount is reduced. Same return in dollars on a smaller investment indicates increased return. This is true regardless if the return is achieved via cash flow or appreciation.

I will use appreciation to demonstrate. We are in a market that appreciation is less certain than it has been for much/most of the last decade. However, for purpose of this example we will have purchased an RE at 90% LTV that appreciated at 5% in the first year (I certainly would not project this high going forward, but as an example it works). Because the property only required I invest 10% of its value (not including any closing cost), the 5% appreciation results in a 50% return from the appreciation. If I had no leverage, I invested the full value (again ignoring closing costs) to obtain 5% return on my investment when the property appreciated 5%.

In addition, the lower investment amount means that the money not invested on this asset can be invested on other investments.  Whether this is another RE, stocks, bonds, Mineral rights, crypto currency is not relevant.  What is relevant is that if you invest this additional money well, it will product additional returns.

As for the rate ...   The rate is less important than the margin between the rate you pay and the return you achieve on that money.  For example, it the rate is 3%, but my investment only produces 5% return this is not a good use of the money (and if the return in taxed will be a net loss for higher income people).  on the other hand, if the rate is 10% but I can produce a 20% return do I care that I am paying 10%.  I would not care that my cost was 10%.

Good luck