Investing in real estate, in general lines, involves compromise and is often more a matter of what an investor is willing to give up than what he admittedly wants.
If I were to ask "What is your speculation objective?" how would investors respond? Most likely the answers would range from "I want to retire at 55", to "I want to start my own enterprise within the next five years", or perhaps to "I want to have adequate money set aside for my children education". We all have many dissimilar ways of expressing what we are trying to accomplish when we set speculation objectives. When all is said and done, however, there are admittedly only three fundamental goals we admittedly intend to achieve. All goal-setting boils down to growth, earnings and liquidity.
We want our real capital assets to grow in value, that is to be worth more at some point in the future than they are today. Then, while we are in the process of accumulating whatever number of wealth we can, we need to originate income out of those assets to minimize costs of owning such as property taxes and maintenance and, possibly, to growth our own salaries or wages. And, finally, we want to be able to swiftly convert those assets into cold cash, should the need ever arise to get through some unexpected crisis, or if a best speculation opening suddenly comes in sight.
That's quite a lot that we want from our real estate investments. The truth is that only few of all investors will have situations so easy as to be able to accomplish all three goals in equal proportions. For the vast majority of us, it will be a matter of seeking compromise so as to couple in our investments only some elements of growth, earnings and liquidity, and not in exquisite equilibrium. This is due not only to the nature and type of the real estate speculation we decide to make at any given time, whether residential, commercial, multi-family rental or a compound of any of the above, or to the situation of the store at the time we make our investment, but also for a quintessential human trait tasteless to all investors.
We spend money on things we need, and we save money for things we want. Which is great, until such time as we decide to reclassify what is that we need and what is that we want. Human nature being what it is, when we see something that we suddenly decide we ‘need' and the money is readily available, our best intentions can wilt and disappear instantaneously. If the cash is not in the savings account already, we can pay an unexpected visit to our kindly neighbourhood banker who will be more than thrilled to develop the money secured by our real capital assets, or to refinance our existing real estate loans. This is, in greatest analysis, how consumerism works.
There is no doubt that the judicious use and administration of debt can accelerate the accumulation of wealth. In Finance, this is called ‘leveraging': the use of borrowed money to meet speculation objectives, particularly growth and income. However, financial leverage is a double-edged sword: using other citizen money to invest also increases the risk connected with the investment. It is bad adequate to lose one's own money if a real estate speculation sours. It is much worse, however, to lose the banker's money - one may swiftly contemplate how unfriendly, all of a sudden, the kindly neighbourhood banker may become.
Historically, leverage strategies work best and are more popular while times of low interest rates and high appreciation of property values. If, for example, an investor borrows money at 5 percent to buy an speculation that appreciates at the rate of 10 percent a year, obviously the investor will come out ahead. Additionally, in inescapable circumstances the interest charge is tax deductible, thus development the net return even higher. Unfortunately, however, while times of downward fluctuations leveraging may be a risky proposition, as the cost of borrowing may exceed the speculation yield even after deducting interest expense.
So, therefore, when is leverage appropriate? In Finance, the rule of thumb is that every dollar borrowed increases the risk of investing by 50 percent. This means that if an investor has 0,000 of his own money and decides to borrow an added 0,000, he increases the risk by 50 percent. If he borrows 0,000, he doubles the risk. If he goes as far as borrowing 0,000, he increases the risk by 150 percent. Therefore, if the real capital asset chosen by our investor would ordinarily yield, say, 10 percent, he should expect a return of somewhere in the area of around 10 + 5 = 15 percent to account for the extra risk, if he pays 0,000 for the real property he is acquiring, 0,000 of which are financed by a lender.
This ratio holds true for leveraged investments of higher or lower proportions too. For instance, if the investor matches each dollar of his own money with 50 cents from the bank, his startling return should be at least 25 percent higher than if he only used his own money, or 10 + 2.5 = 12.5 percent. Likewise, in the case of 0,000 financing the startling yield should be 20 percent. And then, of course, there is the real big one: the 100 percent leverage, also known as the zero-down option (the one they show on Tv at midnight), with the investor using none of his own funds (because he doesn't have any, since he just landed straight out of the Mongolian desert - like the chap on Tv). On a buy price of 0,000, the yield should hover to on or about 10 + 5 + 5 = 20 percent. On a buy price of 0,000 it should be in the range of 10 + 5 + 5 + 5 = 25 percent and so on.
Luigi Frascati
Real Estate Investing: The Value Of Compromise