By Chris Anderson, Ph.D.
During the course of my travels, I have met some very interesting individuals who have enjoyed HUGE successes in the real estate markets. I have interacted with one individual that literally produced several hundred million dollars in real estate equity in a short period of time. What was his secret? OPM which is short for Other People's Money.
Before you get too excited, this same individual very rapidly became worth minus several million dollars. How did that happen? OPM! Without getting into all the gory details, this individual was making millions by highly leveraging real estate transactions in the early 1980's. To finance his deals, he used bank financing, private financing, and any other mechanism that he could; i.e., OPM. Unfortunately, the market had a major correction and cost him everything plus forced him into bankruptcy (Don't worry, he is doing just fine today but has made some major corrections to how he operates with leverage).
In preconstruction, we have heard story after story of how people have made small investments and turned them into HUGE $100,000+ gains. How have they done it? Simple, using leverage and OPM. Since nobody can foretell the future and how the use of leverage might impact us, I think it is wise to step back and make sure we understand everything about leverage: specifically, how do we use it to our advantage without taking excessive risks.
Let's look at the seven key aspects of leverage as they apply to preconstruction investing.
Leverage can play a key role in increasing returns; This is the fundamental reason people like leverage. Suppose you purchase a condo in preconstruction for $500,000 and it appreciates to $600,000. That is a 20% increase. However, if you only put down 10% ($50,000), then you have "levered" your cash-on-cash return to 200%!
Leverage plays little role in changing the cash return of an investment; In the above example, the total cash gain was $100,000 regardless if you put 1% down (10,000% return) or 100% down (20% return). This is where % return can get a little misleading if viewed out of context.
Pre-construction Leverage can be obtained WITHOUT Financing; Leverage is one of the MAJOR attractions to real estate investing. Normally, you actually have to purchase a property, with financing, to obtain leverage. This is not true in preconstruction investing where you can put down a small % but then obtain appreciation from escalation of the entire purchase price. This is why everybody likes preconstruction.
Pre-Construction Leverage Still Requires Good Credit Unless You Are Willing To Take a 100% Loss. When you put down your non-refundable deposit on a hard contract, then you may have to close when that property is complete. This can occur because of developer rules or because of a softness in the flip market at time of completion. If you have poor credit and cannot close, then that means you will lose your entire deposit; i.e., a 100% loss.
Leverage Applies Equally To Losses; In the above example, suppose you had to actually sell the condo for $475,000 due to market conditions. This is a 5% loss of the total purchase price which probably does not sound too bad. However, this is a 50% loss of the original investment because of the 10X leverage.
Financed Leverage Requires Good Credit; In some preconstruction opportunities, such as when land is purchased with no payments for a period of time, or when houses are purchased using construction to permanent loans, then the leverage will impact your ability to obtain future loans. As a lender sees more and more leverage on your financials, they will get more and more nervous about lending on a new acquisition.
There Is A Simple Way To Separate Leverage In Your Investment Decisions; When people only look at potential gains of an investment, their decisions can be cloudy. So they may look at a 200% gain and decide that this is something that cannot be missed. But what most fail to do is factor in the risk side as well. Every investment MIGHT not work resulting in a loss. If that loss is small, relative to the potential gain, then it is probably a reasonable investment. On your next investment decision, simply estimate the ratio of % Potential Gain divided by your estimated % Potential Loss. Once (if) you are comfortable with that ratio, then you can always then look at "levering" your return.
Hopefully this gives you an appreciation of the use of leverage in preconstruction investing. Leverage can be your largest friend to creating wealth if done properly but can also produce a major problem if caught on the wrong side.
About The Author
Dr. Chris Anderson is the founder of http://www.GetPreconstructionDeals.com and is referenced in many venues including the New York Times and USA Today. Get his weekly, thought provoking articles by signing up today!
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