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Last Updated: May 14th, 2012 - 22:24:01 |
By the time you've owned and managed one or two piece of real estate, and watched the spendable cash profits roll in, your appetite will probably be whetted for more. Let's consider how you can expand.
Basically, the way to do so is to go deeper into debt.
Do you flinch at the first thought of this? That's understandable. "Pay as you go" sounds more solid and sensible than "Go now, pay later". For generations our puritan heritage has kept us feeling that we shouldn't borrow money except as a last resort, and should pay it back as quickly as possible. "Debtors" were much inferior to ordinary people, we were taught; in act, debtors' prisons were part of the Anglo-American landscape for centuries.
But economics have changed, and so have our customs and beliefs. There's no longer anything discreditable or unwise in using carefully calculated amounts of "rented money" - which of course is what we do when we borrow.
Financial institutions are happy to lend us money if we pay enough rent (interest) for it, show that we'll be able to pay it back and secure the loan with something of sufficient value (the collateral or security) if the lender consider this necessary.
Using these other people's money is a sound and ethical way to build our own financial security. We're really helping the lending institutions as well as ourselves. They're in the business of lending money, for the profit of all concerned.
When we operate on credit - that is, on borrowed money - we use what financial people call "leverage". Leverage is the big basic principle behind all successful real estate buying. Therefore, we'd better examine it at sufficient length to make sure that it is clear.
Using leverage is part of many normal family transactions. It's what we do when we buy household appliances on the installment plan, or when we finance the purchase of a car.
Is this better than saving up until we can pay the whole price in cash? Paying cash means we pay no interest charges, so our total outlay is smaller. In that way we save. But maybe we lose in other ways. Let's consider a typical transaction. I buy a car, I pay the automobile dealer about one-fifth or more of his asking price, in cash. I agree to pay the rest - plus interest or a "financing charge" - to him or some financial institution in installments spread over a period of many months.
Why do I sign up for this kind of transaction, which obviously will cost me more than paying cash? Either because I don't have enough spare cash, or because I have the cash but prefer to use it for other purposes. I get immediate possession of the car for a fairly small down payment, and I figure that this offsets the disadvantages of the high cost over the long pull.
In buying a home, the same basic thinking applies. It's better to borrow heavily than to save up until the full purchase price is accumulated - which might mean foregoing ownership of a nice home for many years or maybe forever. Even the people who have an abundance of ready cash may find better uses for it than paying the full price for a house on the day they take possession. They prefer to eat their cake and have it too, in a sense - they become homeowners and still keep most their cash, by "leveraging" the transaction. For a small down payment they get a big immediate benefit, just as a small lever can move a big weight.
Smart investors use borrowed money in most realty investments even when they are rich enough to buy the property free and clear. They prefer a deal that keeps their own cash outlay at a minimum. They don't mind paying high interest on borrowed money if their overall return will be higher yet. The more leverage they can use (i.e., the smaller proportion of their own money, the greater proportion of other people's money), the bigger the potential for a high rate of return on their own money.
The following explanations might have some unrealistic money and percentage figures, depending on the money market on the day you read this. Don't worry about that, concentrate on learning the principle involved.
To see what a difference leverage makes, let's suppose you have $10,000 to invest, and have been offered two properties. Property A is for sale at $10,000, but the seller wants the full price in cash. Property B is priced at $50,000, but the seller says, "You can have it for a down payment of only $10,000 if you'll pay interest of 8 percent on the rest". This means you would take out a mortgage or trust deed for $40,000 on which you would pay $3,200 interest in the first year alone. Sounds like a lot to pay just for interest, doesn't it?
Which is the better deal? It depends on the approximate net income that each property would bring you. Property A's net income, you find, is $1,000 a year. Property B's net income is $5,000 a year. Both properties are thus yielding 10 percent on their selling prices. That's why the owner of B can price his property five times as high as the owner of A.
Now which is the better deal? Analyze them. If you put your money into Property A, you own it outright. Sounds great to "own it outright", doesnĄ¯t it? Just thinking about it makes you feel solid and prosperous.
Furthermore, your $1,000 annual return on Property A will be a 10 percent yield on the $10,000 you invest. That also sounds good. It's sometimes hard to find a 10 percent yield in other types of investment.
But wait! Do you realize that Property B will bring you an 18 percent yield? Your net return, after paying interest, will be $1,800.
Here's the arithmetic on Property B. its net operating income of $5,000 will be reduced by the $3,200 interest on the mortgage. But that will leaves $1,800 a year in your pocket for the $10,000 cash you put up.
In other words, Property B will earn an extra $800 for you every years, simply because the earning power of the borrowed money is $800 greater than what you pay to "rent" the money. Your investment in Property A would use no leverage; but Property B would give you considerable leverage - or, as some people phrase it, by investing in B you would "Successfully trade on your equity".
To Read the Part II of this article, Click Here
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