<p>I dont seem to be getting the idea of leverage. I googled it and all I understood was that some firms often use their debt to invest? I dont get it. Why? How do they benefit? How do they increase efficiency and/or their profit?</p>
<p>Lobzz, the basic premise of leverage is to use other people’s money. Interestingly there are actually two types of leverage when it all boils down.</p>
<p>The first type,which is the most well known is to borrow money from some financial institution or person.</p>
<p>Here is why you might want to do that. Lets say that you see a great piece of real estate for $100,000. Lets assume for the moment that you put up all of your own cash. So your investment is $100,000. If the property appreciates a measly 2%, you have made 2% on your money calculated by taking the return, which is $2,000 and dividing in by your investment,which is $100,000. Are you with me?</p>
<p>Now lets use leverage and assume that you can borrow $90,000 from the bank and only use $10,000 of your own money. If the house appreciates or depreciates, it will go u p or down REGARDLESS of your cash investment! Thus, if the house appreciates the same 2%,which is $2,000, you have made a whopping 20% on your money ,which is calculated by dividing the return ofc $2,000 by your cash investment which is only $10,000 and NOT $100,000 since the bank lent you the other $90,000. Do you see this?</p>
<p>The second and some consider the better form of leverage, is to get the other money from other investors for you! Donald Trump has used this technique well as have other successful investors. If you can get some rich person to spot you the whole $100,000 to manage the property and find the deals, you make an infinite return since you don’t have any of youor money at stake!</p>
<p>This last version has many iterations,but I think you should understand the basic point.</p>
<p>Thanks taxguy… I get the first part. But about the second part… These venture capitalists(im guessing) just give you the money and all they get in return is managerial roles and what else?</p>
<p>and sorry again but about this part “you have made 2% on your money calculated by taking the return, which is $2,000 and dividing in by your investment,which is $100,000”. What do you mean by “dividing in by your investment”? you’ll end up with $102,000. Thats basically it, right? </p>
<p>You seem to know your stuff:)</p>
<p>and again</p>
<p>“Now lets use leverage and assume that you can borrow $90,000 from the bank and only use $10,000 of your own money. If the house appreciates or depreciates, it will go u p or down REGARDLESS of your cash investment! Thus, if the house appreciates the same 2%,which is $2,000, you have made a whopping 20% on your money ,which is calculated by dividing the return ofc $2,000 by your cash investment which is only $10,000 and NOT $100,000 since the bank lent you the other $90,000.”</p>
<p>Im guessing this is one of the primary causes of today’s financial crisis?! People think they can leverage their way by taking money from the banks and no one ends up paying? Am I mistaken?</p>
<p>Lobzz, what does $2,000 divided by $100,000 equal?</p>
<p>point 02. but why? you’ll ultimately be making 2,000 on a hundred thousand dollar investment, which, I see, is why people opt for “choice B”</p>
<p>Oh, so its just making 2% profit as opposed to the 20% you’d make in situation B. And then people dont think about paying these banks back, do they? lol</p>
<p>Im sorry, excuse my ignorance. These topics are of great interest to me and I love understanding each and every detail.</p>
<p>Lobzz, the second part occurs because folks with money want other folks to help them invest it and manage it. For example, I know a girl who will help find properties for investors and finds folks to put up the money. IN return she gets a whopping 50% ownership in the deal. Since no money is her own, she gets unlimited leverage. I can’t explain this better than I did.</p>
<p>Oh. Yeah, I see it clearly now. Nothing like anecdotes. Thanks for the help, taxguy.</p>
<p>Hey taxguy, im sorry to bother you again but I just spontaneously thought about it again… Say I find a house for $100,000. I only have $100,000 and I spend it all and then the house appreciates by 5%. I’ll make $105,000. Now, if I use $10,000 and BORROW $90,000 and manage to sell the house for $105,000, I’ll have $195,000 (90,000+105,000). I still need to pay the bank back WITH INTEREST! I’d have less than $105,000</p>
<p>Still dont get it:(</p>
<p>OK, I tutor too much for my kids’ elementary math :). Let’s do arithmatic. </p>
<p>1) John has $100K and invest in a $100K house. He sells after a year with a 5% appreciation. Jonh has a net profit of $5K. John’s return rate is $5K/$100K=5%</p>
<p>2) Jane also has $100K, but she finds a bank to lend her $900K at an interest rate of 4%, so she has $1,000,000 in total to invest. She buys TEN of the $100K house and sells after a year with the same 5% appreciation. She has a return of $50K from selling the ten houses, but she has to pay interest to the bank $900K*4% = $36K, so Jane’s net profit is $50K-$36K = $12K. Jane’s return rate is $12K/$100K=12%. With SAME amount of OWN money, Jane uses leverage (borrow from bank) to enjoy a higher return 12% vs. John’s 5%. </p>
<p>Critical Thinking:</p>
<p>If interest rate is higher than the housing appreciation rate? Is Jane still better off?</p>
<p>Does anyone mind if I send this thread to the WSJ? It’s a gem. All of the various types of private equity are confusing in their own way but this tread would have every VC and LBO guy in stitches.</p>
<p>Yeah I got that! there is no need to mock, I could just as easily say its your fault for not understanding my question. Now, im just going to ask this point blank. What I meant to ask was: What if the interest rate is higher than the rate of appreciation?</p>
<p>Oh but a_mom already asked that. Its risky. The interest rate could be very high, in which case you’re screwed.</p>
<p>Wait… Let me apologize one more time. haha. Im too much of an idiot…I think im going to stop posting on CC haha. Internships and financial analyzing are making me go crazy. Again, I would like to apologize. I just realized every single mistake I made. Each and every one of them. :D</p>
<p>Don’t forget: leverage is a two-edged sword. It multiplies your profits but also multiplies your losses! If each house depreciates in value, your losses can be staggering if you only put in a low down payment on each property.</p>
<p>One more point I want to emphasize. Leverage increases your tax write-offs substantially.</p>
<p>Example: I buy a $100,000 investment property in January that I depreciate over 27.5 years,which is the depreciation life of residential rental properties. Ignoring any allocation to the land, I would write off about $3,485 per year. If I paid all cash for the property, the property would throw off 3.5% in depreciation write-offs each year.</p>
<p>Lets say that I my cash investment is $10,000 and I borrow the remaining $90,000 from the bank, my depreciation write-off remains at $3,485. However, I am generating a whopping 34.85% in yearly depreciation deductions on my $10,000 cash investment! Imagine having ten properties like this!</p>
<p>i dont get one thing. weather ur return is 5% or 25% ur profit or loss will be the same so how are u benifiting from leverage ?? apat from the tax reductions.</p>
<p>^Your basically making more profit (check the percentage). If you buy a house worth 100,000 with 5% appreciation with a 3% in interest rates, heres what you do: pay 10,000 and borrow 90,000. That way you’ll sell the house for 105,000 and then pay 92,700(I think) and that’ll leave you with 12300 which is about 20-23% profit as opposed to the 5% you would have made by paying for the house in full. Am I correct, taxguy?</p>
<p>Remember John only makes 5K from his 100K, but Jane makes 12K from her 100K. The profit is NOT the same. (Consider paying interest but ignoring the tax write-off from depreciation for now).</p>
<p>The point is, although EACH house generate the same 5K profit, Jane manage to buy 10 of the houses by borrowing other people’ money!!!</p>
<p>====
Cross post.</p>