The Power of Leverage/Using Other People’s Money
Note also the power of using OPM (Other People's Money) or leverage (aka debt). It increases the IRR on your equity and it allows you to use a limited amount of capital to do more of whatever it is you are planning on doing.
Leverage is usually interpreted (especially by Banks) as increasing risk too but as you will see in the rental home example we are using here, it may be that if you develop five rental units instead of one, your risks (and your Bank’s exposure to you as well) may go down not up despite higher gearing.
Archimedes Clearly Understood the Power of Leverage
If you use your equity to build five units instead of one (i.e., you are putting 5% down on each unit instead of 25% and financing the rest), and if one tenant leaves, you will have a 20% vacancy rate instead of 100%. The free cashflow you are earning from the other four (still occupied) units can assist you in paying the mortgage for the vacant fifth unit.
If the average vacancy rate for each unit over a ten year period is, say, 10%, then the probability that all five units would be vacant at the same time is pretty low (0.1 to the power of five or just .001%). So, as entrepreneurs, we can argue (with our Bank) for more leverage not less.
Obviously, the Bank will say:
1. If you put down more equity, they will be looking at a better debt to equity ratio and that means if asset values tumble, their loans are protected by your equity since in a Bankruptcy or Power of Sale proceeding, the secured creditor gets paid first.
2. If you only have one unit and it becomes vacant, your income from other sources (the cashflow coverage for your loan (in this case, your mortgage payment)) is relatively higher than if you had to cope with all five units suddenly becoming vacant.
This is what I like to call the ‘nuclear bomb scenario’ or what other people call the Banks’ ‘belt and suspenders’ approach to lending. Banks generally only like to lend money to entrepreneurs who don’t need it (i.e., that have enough of their own cash to start a new venture).
From your POV, your cash on cash returns are much higher if you build five units. The spreadsheet shows if you leverage your $37,500 in equity into five rental properties (with 5% down on each unit), you have a cash return of $254,052.85 over five years as compared to $89,291.00 if you can only build one unit (with a down payment of 25%).
Bottom line, you need a sophisticated, motivated lender before you can do highly leveraged deals.
