Understanding Leverage In Commercial Real Estate

Understanding Leverage In Commercial Real Estate

Understanding Leverage In Commercial Real Estate
Commercial real estate has many tools that can be used to​ maximize one's return on investment (ROI) .​
Among the​ many tools to​ choose from, leverage is​ one of​ the​ most effective ways to​ limit (or omit) the​ amount of​ personal money you put in​ a​ deal, and​ see the​ highest return possible.
In order to​ understand leverage in​ commercial real estate, you must completely understand what it​ is, and​ the​ main factors that determine if​ leverage is​ positive or​ negative .​
Unfortunately, if​ not prepared properly, leverage can completely destroy the​ income producing capabilities of​ a​ property and​ leave the​ owner's income in​ the​ red.
Using leverage to​ your advantage can mean more effective investments every time, either allowing you to​ do less deals per year, or​ greatly increase your wealth in​ a​ short amount of​ time .​
Leverage is​ magic in​ commercial real estate.
Leverage is​ directly related to​ the​ amount of​ money borrowed on a​ deal, compared to​ the​ current value and​ potential value of​ an​ income producing property .​
Leverage occurs when money is​ borrowed at​ a​ certain interest rate that is​ less than the​ rate of​ return on a​ commercial property .​
Let's look at​ this transaction in​ detail to​ see how the​ investor can limit the​ amount of​ personal capital put into a​ deal versus the​ money returned by the​ property.
There are many different styles and​ purposes of​ purchasing property, and​ none of​ them are wrong, or​ better than another .​
It is​ simply reflected by the​ investor and​ his or​ her intentions .​
However, for​ the​ most part, the​ least possible amount of​ personal money that can be invested in​ a​ deal means larger returns.
Why? Because when you borrow $500,000 on a​ property at​ a​ 6% interest rate amortized over 25 years, you are paying the​ principal amount every month, which is​ covered by the​ income of​ the​ property .​
By paying to​ borrow the​ money, you can literally leave your money in​ the​ bank (or put it​ to​ some other asset producing use), have the​ property pay for​ both the​ loan and​ interest, as​ well as​ return a​ huge sum of​ cash, which only adds to​ your personal wealth.
If you had used your personal money, that amount would have to​ be subtracted from the​ total amount earned, as​ opposed to​ only a​ fraction of​ the​ money borrowed .​
Positive leverage is​ when the​ interest rate of​ the​ money you are paying to​ borrow is​ less than the​ investment's return percentage .​
a​ great amount of​ cash can be found in​ this difference .​
The higher performing the​ property, the​ more money is​ to​ be made.
In order for​ this to​ happen, leverage must be accompanied by a​ loan with long payment terms and​ a​ fixed interest rate that is​ amortized in​ equal payments over the​ life of​ the​ loan .​
It is​ true that these terms are not always available .​
However, there are many commercial public and​ private lenders that are willing to​ negotiate terms in​ order to​ see a​ sound return.
When a​ loan has a​ long life, a​ fixed rate, and​ equal monthly payments, the​ principal reduction increases after every payment, while at​ the​ same time, the​ interest amount is​ decreased .​
This occurs when the​ same amount is​ paid every month, causing the​ principal amount to​ be paid lower, so, in​ turn, the​ total amount of​ interest is​ decreased .​
You continue to​ pay the​ principal amount at​ a​ lower interest payment every month.
When your property is​ leveraged properly, you have plenty of​ time to​ pay off the​ loan, and​ cash is​ generated by the​ property to​ pay off the​ loan as​ well as​ give you maximized returns on investment .​
Your money does not even have to​ be involved in​ this process, because the​ income covers the​ borrowed money, the​ interest and​ your return as​ well.
It is​ really amazing to​ see how this simple math can mean such huge results for​ the​ commercial real estate investor.
Leverage can be dangerous, however, especially if​ the​ property does not perform as​ intended, and​ it​ does not produce the​ cash necessary to​ cover the​ loan, interest, as​ well and​ your return on investment .​
When the​ investor owes more than the​ property is​ worth, the​ property is​ considered over-leveraged, and​ this is​ a​ dangerous situation for​ an​ investor to​ be in .​
Money can be lost, and​ personal money may have to​ be used to​ keep the​ property performing .​
The investor may not be able to​ pay the​ interest and​ principal in​ a​ timely manner, causing the​ property to​ go into foreclosure.
Leverage must be taken seriously, and​ the​ mortgage market must be carefully watched, especially if​ the​ loan terms are adjustable-rate instead of​ fixed rate .​
Use leverage to​ your advantage to​ yield the​ most money from your investment without even investing your own money .​
Do be aware that leverage can go in​ a​ negative direction .​
Be sure to​ have accurate and​ supportive income forecasts so that you know the​ loan will be covered, as​ well as​ the​ return you expect to​ gain from the​ property.

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