Want to build a real estate empire or grow a business from scratch, but you don’t have the cash? Try a little leverage.
Borrow to buy real estate
It was the mid-1980s and D.G. Southen was only 24 years old when he bought his first investment — a house near the University of Western Ontario in London, Ont. He borrowed $20,000 from his parents to put a down payment on an $80,000 house. To pay the mortgage and other costs Southen rented the place out to six other roommates. “I slept in an unheated attic and paid the mortgage from the rent I collected.” After a few years Southen grew tired of living with so many people, so he sold the house for $108,000, paid his expenses and used the net profit for a series of down payments on four condo units near the university. Southen was fortunate: he caught an “updraft” in the housing market and made a lot of money.
Over the years, Southen has continued to borrow to invest in rental properties. These days he no longer looks at buildings with less than 40 units. “I’m older and I need to allocate my time more wisely, but I had to start somewhere.” The part he likes best is that once a property’s mortgage is paid off, it will keep spinning off cash every month from the rent. “Most people will draw from a retirement fund when they stop working and most will deplete that asset as they earn their income,” he says. “Not me. I’ll earn an inflation-adjusted $50,000 from just one of my holdings, and I won’t ever touch the capital.”
Large apartment buildings may be out of the equation, but the good news is that real estate is probably one of the more accessible ways to invest borrowed money, says Talbot Stevens, financial educator and author of Dispelling the Myths of Borrowing to Invest. “It’s a mini-business that doesn’t have a lot of complexity to it. For the average person real estate can be a good strategy.”
To make sure you don’t get burned, the key is to remember that borrowing to buy an asset, called leveraging, magnifies both the gains and the losses. To understand how this works consider what happens if you put 10% down on a property worth $300,000. Your original investment is $30,000. If the house goes up in value by $60,000 and you sell, you’ll make a $30,000 profit (before interest, taxes and expenses). So the house only went up in value by 20%, but the return on your investment was 100%. That’s how leverage juices your returns.
Now consider the downside: What if the house drops in value by $60,000 and you sell? If that happens, you won’t get any of your $30,000 down payment back, and worse, you’ll also owe $30,000 to the bank to pay off what you’re short on the mortgage. In this case, the investment has declined in value by just 20%, but you’re underwater by 100%. You’ve lost more than you invested to begin with.
That’s why the key to building a successful real estate portfolio using leverage is to invest in property that is cash-flow positive. That means the income you get from renting out the property covers all your expenses, including the mortgage, taxes, insurance, maintenance, repairs and a contingency fund. That way your property will be making money for you whether house prices go up or down — so hopefully, you’ll never be forced to sell in a down market.