Right now, we’re going to discuss leverage.
Bob Nelson, Eugene real estate investment broker
Bob Nelson: Let me describe for you in as simplistic of terms, as I can, because I can’t use pie charts, and I can’t use diagrams, because you’re driving. I assume that you’re driving home, and you’re driving in a safe and productive manner. Let me see if I can’t make an example here. If I were able to buy a property that had, let’s say, a 6% capitalization rate. Restated, if I owned it free and clear, that property would produce a 6% cash dividend at the end of the year. If I took all of the cashflow that came off of the property, put it into one account, divided that cashflow by the price of the property, that would show that it had a 6% productivity. We’d call that a 6% cap rate.
If I could buy a property that had a 6% capacity to generate cash, and I was able to borrow money at, let’s say, 4%, I am borrowing money at a cheaper rate than what the property is capable of producing. Now, this is the beauty of the process. Envision for a moment a circle. Divide the circle into four pieces, a vertical line and a horizontal line. You’re going to come up with 25% of the price of that property in the form of a down payment at time of closing. You miBob Nelson, Eugene real estate investment expert, explains how leverages works, and the benefits it can have for your investments.%, so you’re covering one quarter of the pie. The lender is covering and funding three-quarters of the pie.
Again, the property produces a 6% return. The lender requires a 4% payment. So for each quarter that the lender has, it’s earning six, you pay them four, you get to have 2%. That’s 2% for one quarter, another 2% for another quarter, another 2% for the third quarter that the lender came up with. That’s 6%, plus your 6%, that is a 12% yield on a property that you only acquired that produced a 6% dividend. Isn’t that interesting? That’s how leverage works. Borrowing at a rate less expensive than the asset that you acquire.
Join Eugene, Oregon, real estate experts: Bob Nelson, Real Estate Investment Broker with Pacwest Real Estate Investments, and Marcia Edwards, Residential Real Estate Broker with Windermere Real Estate, daily at 5:30 on KPNW for the “Real Estate Today” radio show.