Understanding the importance of leverage in commercial property investing finance is vital to making a profit with commercial real estate. The term leverage refers to an investor’s ability to borrow against a portion of the purchase price or value of the collateral. By borrowing cash from a lender you have used someone else’s money to increase the size of your investment. Unless your goal is to own a few tracts of land to give to your heirs you need leverage to compete in commercial real estate.
Leverage can significantly enhance the profitability of an investment. By wisely using dollars provided by a lender you can make money on the money that you invest and on the money that you borrowed. The key to successful commercial property investing finance is to find those deals that will earn higher returns than the cost of the money you borrowed.
For example, assume that you find a commercial real estate investment that earns 9% per year and that you can borrow 75% of the money needed to purchase the property at an annual interest rate of 6%. You will need to invest your own cash to cover 25% of the purchase price for which you will earn a 9% annual return, but you will also be earning 9% on the 75% that you borrowed.
However, you are only paying your lender 6% for the borrowed funds therefore you are earning 3% each year. 3% may not seem like a windfall but when you’re using leverage properly it allows you to make larger purchases and take control of larger assets. 3% is not much of $100K deal, but it looks much better when the deal is 3 million.
While leverage can greatly enhance the profitability of investment it clearly increases an investor’s risk exposure. Problems arise when an investment is not producing a return that is greater than the cost of the money borrowed. Using our previous example, if you borrowed money at 6% per year, but your investment earned anything less than 6%, you’re losing money and earning low or negative return. The better real estate investor understands commercial property investing finance and prepares for the unexpected. If you’re going to use leverage you must ensure that you will have the means to make payments under any circumstances.