Everybody I know loves LEVERAGE when it comes to real estate.It’s a beautiful and scary tool, kicking appreciation, depreciation, and cashflow into overdrive.It amplifies everything. You can make a lot of money really fast and go broke in months.Here’s how it works
Let’s say you’re buying a $1MM asset at a 7 cap. Meaning it generates $70k in net operating income (before debt service)You put $300k down and borrow the rest ($700k) from a local bank.At a 4% interest rate on a 20 yr amortization schedule you’re paying about $25k in interest and $25k in principle a year.That’s 20k in cashflow on your $300k cash investment. A 6.6% CoC return.You need better debt terms to buy 7 cap deals nowadays. But let’s continue.It’s powerful because of appreciation and depreciation.You only paid for 30% of the asset but you get to enjoy these two things on what the bank paid for too, or 100% of the asset.Let’s say you straight line depreciate this thing over 39 yrs.2.5% of total cost per year.
Depreciation isnt a real expense that comes out of your checking account.It’s a form of tax deferment and is written off as an expense on your taxes. It lowers your tax liability.2.5% on your $300k wouldn’t be much. $7.5k.But you get to depreciate that $700k the bank paid for as well. That’s the cheat code.2.5% on the $1MM is $25k.That’s 8.3% of your initial cash investment. And you get to write this off every year for 39 years.But there’s more. Not every part of the building you buy is depreciated on a 39 yr schedule. The windows, doors, HVAC, curbs, landscaping, etc is on a 7 year or 15 year schedule.So you pay a firm to do a cost segregation for you and assign values to all of these things.There’s this little loophole in the tax code to encemtivize buying and holding assets.Bonus depreciation.It comes and goes based on political administration but it’s here now.It allows you to write off everything under a 15 yr life in year one. The first year you own it!
In a lot of cases you can get 30%+ of the total price (bank plus your cash) assigned to this shorter lifespan and thus depreciated the first year.30% of $1MM is $300k.But $300k is 100% of YOUR $300k investment.Leverage AMPLIFIES your deductions.So while this asset generates $45k ($70k in NOI minus $25k in interest expense) in taxable income, you claim $300k in depreciation to offset this.If you’re a real estate professional (which is a tax treatment) this can offset your active income from other W2 work.If you take all of your taxable income and buy new assets under this structure every year, you can get pretty close to paying nothing in taxes.The taxes do catch up when you sell the asset with something called recapture. Unless you do a like-kind (1031 exchange) purchase.So the leverage allows you to achieve favorable tax treatment.
What about appreciation? The fact that your asset gets more valuable every year.Let’s be safe and assume 3% appreciation. On our $1MM property that’s $30k a year. At the end of year one it’s worth $1,030,000.30k is 10% of your original $300k investment.The $700k bank note doesn’t grow, it shrinks as you pay it, and the bank doesn’t get the upside from your asset they helped you pay for getting more valuable.They paid for 70% but YOU get 100% of the appreciation.The value of your $300k APPRECIATES by 10% every year because it happens to the banks cash too.This is powerful and compounds over time.If you can improve operations you can enjoy higher levels of appreciation.Let’s say you increase NOI by $20k the first year. From $70k to $90k.You might achieve 20% appreciation THAT YEAR.But it’s 20% on the entire purchase price of $1MM. Not just your $300k you put down in cash.So you could enjoy $200k in appreciation on your $300k investment. Or 66% gain in one year.Leverage amplifies your gains in a major way. A couple big scores and you can double and triple or even 5x your money.Now let’s talk about the danger here.
This all works against you just as easy as it works for you.It AMPLIFIES your losses.If the value drops by 20% your equity drops by 66%.If you’re operating income drops by $20k your cash on cash return is suddenly negative.And since you’re levered up it takes smaller and smaller percentages to have BIG impacts on you.NOI is generally 50% of revenue. But expenses rarely drop, if ever.So if your revenue was $140k to generate that $70k in NOI, let’s think about what could happen to that.If your sales drop by a modest 15%. Like say a pandemic made some folks unable to pay you rent.That’s $21k of revenue gone. Expenses stay at $70k. Your NOI goes from $70k to $49k.Your revenue only went down 15% but your NOI just dropped 30%.And there’s more. Your debt service is still $50k a year. Prior to the drop your cashflow was $20k a year.Now it’s -$1k. You’re suddenly loosing money. All it took was a 15% drop in revenue for all of your cashflow to go away.Your cash on cash went negative.
What happens to appreciation in an event like that? The facility was valued at a 7 cap.
Meaning divide NOI by .07 to get your value.Your NOI is now $49k. $49k / .07 = $700k.Your property just became 30% less valuable. What about your equity?That $300k you put down?It vanished. You have no equity.If you don’t have the cash to weather the storm you are selling at a discount and you’re out. Broke.It’s all about management and operations. That’s the risk factor of RE.If you can’t keep expenses in line and hold on to or raise revenue you’re toast. That means more customers. Customers who pay on time.Real estate is cyclical. You can’t predict appreciation.
This Article first appeared on twitter, created by Nick Huber and was posted here with his permission.