A basic understanding and application of sound financial concepts is essential for sustainable success in real estate investment. Financial intelligence has been defined in various ways but for our purpose, it is an understanding of how money works so that you can make, manage and multiply money and achieve your financial goals. In pursuit of the goal of having enough resources to meet your financial needs and more, real estate investment is one of the popular vehicles that many have used to achieve their financial goals. We need to examine a few financial concepts that are applicable to real estate investment, which when understood will help you in the journey to financial freedom.
One of the foundational concepts that you should understand is that of leverage. This concept was discovered and popularised by an ancient Greek philosopher called Archimedes. A leverage is a tool that you can use with a fulcrum to lift heavy objects. It is little in size compared to the object, but by application of scientific and engineering principles lifts the object. He was reputed to have said that if he had a lever long and strong enough he could lift the entire world. Leverage, in real estate, refers to financial tools that you use to enable you to use your limited resources to acquire bigger and better properties.
In real estate investment, leverage involves the use of a little of your own money and other people’s money (also called OPM) in the form of bank loans, co-operative money, soft loan and other forms of funding to acquire a property that you would otherwise be unable to afford. The result of this leverage is that you will be able to make more from the sale of such a property; as if you had fully paid with your own money. The percentage of returns on your investment is significantly higher.
However, for this concept to work for you, the cost of the fund must be such that after the interest is calculated, it is still less than the return that you will get on the sale of the asset after all expenses has been paid. Therefore, it is important to understand that debt is neither good nor bad. It all depends on what you do with the debt. A bad debt is the one that you use to acquire something that takes money out of your pocket. A good debt is a debt that makes you richer by putting money in your pocket after the debt is paid.
When you are seeking to apply this concept to real estate investment, you need to focus on at least three primary factors that could make or mar the investment depending on how you manage them. The first is the cost of the property. You must ensure that the property in question is bought at a fair price or preferably at a discount. Leverage does not mean that you should be careless and buy any property at any price. Leverage is like fire. It is neither good nor bad. However, if handled badly, it could not only burn but also destroy.
The next factor that you should carefully consider is the cost of the fund that you intend to use as a lever in the transaction. If the cost of the fund was too high, it will eat into your profit and if there was any hitch in your calculations, it could multiply your debt .High interest could multiply the cost of funds rapidly. This could lead to the loss of the property and bankruptcy.
The third but often neglected factor is the net income from the property. If you use leverage to purchase a property that you are living in, this will only take money out of your pocket, in the form of monthly mortgage payments. However, once the value of the property increases beyond your outstanding debt you might be able to access the extra financial value that is referred to as ‘equity’. If you are renting the property but the cost of your mortgage repayment is higher than the rental income and you have to add some personal funds to pay your debt monthly, this is referred to as negative gearing. While this might be useful for tax purposes in some jurisdictions, it is a risky practice and does not meet our standard of an asset that puts money in your pocket.
If the rental income from the property is higher than your monthly repayments, this is referred to as positive gearing. The more money it puts in your pocket, the better. This is something that you can calculate in advance by looking at your net operating income from the property.
Your net operating income calculates the rent, less management fees of your agents; allowances for repairs, and any other costs.
Once you understand the concept of leverage, you can apply it in the appropriate circumstances to increase and maximize the returns on your real estate investments. Punch