The previous leverage article covered how the common method for measuring leveraged Return on Investment (ROI) can mislead you by underestimating the work and risk. Add overly-optimistic “magic” numbers to inflate ROI and this article shows how the combination of rosy estimates and ignored risk can trick you into a bad investment.
We will start with the same example as last time:
$250k: invest 100% cash (unleveraged) or 10% cash with 90% loan (leveraged)?
$250,000 [100%] paid in full in cash:
--$26,400 in rents - $3300 expense = $23,100 NOI
--$23,100 / $250,000 = 9.2% ROI
$25,000 [10%] cash down payment [plus $225,000 mortgage]:
--$18,879 in mortgage payments + $3300 expense = $22,179
--$26,400 in rents - $22,179 = $4221 NOI
--$4221 / $25,000 cash in front = 16.9% ROI
example from: Using Financing for Real Estate Leverage
Debt makes you 80% richer?
The example author concluded:
“As you can see, even though your risk increases with leverage, it might be a wise choice when you can increase your ROI by as much as 80% (16.9% is 84% increase over 9.2%) over the full cash in front option.”
The promised 7.7% spread (16.9 over 9.2) was not impressive enough so the author used a percentage of a percentage to make the pro-leverage number 10-times bigger (80%--Who doesn't want to earn 80%?). Almost doubling your ROI would be a good thing but let’s not get carried away too soon.
The pro-leverage conclusion depends on magic numbers.
How many rental markets have perfect 100% occupancy rates, i.e. no vacancies at all between tenants, and no missed payments? Here are some real-world rental occupancy rates/vacancy rates that I quickly found to see how the examples perform with real-life inefficiencies:
(Sorry if a long space appears before the table)
Market | Occupancy Rate (%) | Gross Rent Annual ($) | ROI Unleveraged (%) | ROI Leveraged (%) |
| Hypothetical | 100.0 | 26,400 | 9.2 | 16.9 |
| 2001 Northeast | 94.7 | 25,001 | 8.7 | 11.3 |
| 2001 US urban (inside MSA) | 92.0 | 24,288 | 8.4 | 8.4 |
| 2001 US non-urban | 89.6 | 23,654 | 8.1 | 5.9 |
| 2004-Sep. Texas 6 major markets | 78.0 | 20,592 | 6.9 | (6.3) |
| 2003-Oct. Texas 6 major markets | 77.5 | 20,460 | 6.9 | (6.9) |
Sources: Statistical Abstract of the United States, 2002, Community Connections
- In only one real-world occupancy rate did the leveraged ROI beat the unleveraged ROI.
- In one other case, leveraged ROI broke even with unleveraged ROI.
- In most cases, the leveraged ROI was worse than the unleveraged ROI.
- In 2 cases, the leveraged ROI is losing your money while the unleveraged ROI is still providing almost 7%.
- In the last case, the margin spread (+6.9% v. -6.9%) shows that it is the unleveraged ROI that is 13.8% points higher than the leveraged choice.
Can you feel that $225k of debt making you 80% richer yet?
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