E119 – Smart Use of Leverage in Multifamily Real Estate – Steven Pesavento
E119: Smart Use of Leverage in Multifamily Real Estate
Smart Leverage in Real Estate offers you control, that you can’t find through Stocks or other forms of Paper investments. These are especially available in Multifamily, as typically banks take on 65-85% of the cost of a property. As an owner you’re in control of this property’s destiny and therefore in control of your investment future.
Plus, listen to the example of how a leveraged return dramatically increase the overall ROI on an investment deal.
The key here is using Smart Leverage, as Robert Kiyosaki preaches. Make sure your operation team is in control of your investments when using leverage.
Read the Transcript Here
Title: The Investor Mindset Podcast – EP 119 – MASTER -16 LUFS
Presenter: Steven Pesavento
[000:0:01] Steven: One of the biggest levers that gives real estate investors the ability to dramatically grow their returns and make big money is the use of leverage. But what is smart leverage, and what does that exactly mean and why is it such a poor idea to use leverage in the stock market? We’re going to get into that and more today in this episode diving in to leverage.
[00:00:28] Steven: This is The Investor Mindset Podcast, and I’m Steven Pesavento. For as long as I can remember, I’ve been obsessed with understanding how we can think better, how we can be better, and how we can do better. And each episode, we explore lessons on motivation and mindset from the most successful real estate investors and entrepreneurs in the nation.
[00:00:50] Steven: Welcome back to this week’s episode of the Mindset Minutes on The Investor Mindset Podcast, and I’m Steven Pesavento. And each week I share mindset tips and investing strategies to help take your investing career to the next level. And this week, we’re going to be focusing on the smart use of leverage and why it ends up leading to such better returns for real estate investors and why it’s so not smart, AKA it’s dumb to use it when we’re investing in stock market or other things that we don’t have control of. So as I dive into that, I’m going to be taking this from the perspective of multifamily. The same idea applies regardless of what asset class we’re looking at. But, you know, if you’re just joining us, I really encourage you to take advantage of all the free resources that we’re putting out. Every single week, we’re dropping new episodes and more and more information on the website, so make sure you hit that subscribe button down below, and if you’re looking to dive deeper into understanding leverage and its relation to the benefits of investing in multifamily, then I encourage you to head over to theinvestormindset.com/multifamily – as we’re putting together some phenomenal resources and great training and bringing in experts to be able to help get you and your business to the next level so that you can start getting where you actually want to go. Whether you’re talking about from an active perspective and you want to be an active operator, or if you’re looking at passively investing and taking advantage of some of these with experienced partners, that is definitely going to be the place to check out. So theinvestormindset.com/multifamily -and I look forward to seeing you there.
So today I’m going to be diving into specifically how we can use leverage the smart way to make sure that we can get the most out of our returns. And so multifamily real estate investing in itself offers a huge advantage when it comes to using smart leverage to increase returns, both for operators and for investor partners. So the key here is the term smart leverage and Robert Kiyosaki stated in his book – Financial IQ, that leverage should only be used when there is control. So multifamily real estate investors get the benefit of leverage by increasing the returns while holding on to the upside of control. Plus passive investors receive some of these same benefits without the downside risk of signing on the loan or carrying the liability. And so why do we want to use leverage? Why is this important? Well, it’s important advantage that is available to real estate investors because by adding the use of leverage, investors are able to radically increase the returns in relation to the capital that they’re investing. You know, I’m going to walk through a little bit of an example here, and I’m using simple interest because I want it to be really simple. And if you’re looking for a visual representation of what I’m going to walk through here, you can find an article that we put together at the investormindset.com/multifamily – and the piece is called “Why to consider multifamily and some of the benefits.”
So in this example, there’s two gentlemen who are looking to buy a $5 million multifamily apartment. Hunter is looking to buy that apartment with a 10% down payment, and Mike is looking to buy it with 100% cash. Both individuals have access to the $5 million, and Hunter is choosing to only put 10% down on this property so that he can spread that 10% across multiple properties. One of the advantages of being an operator or one of the advantages of being a passive investor is you get to spread out your money across multiple properties. Well, Mike’s taking a little bit of a different approach. He’s taking a much more conservative approach in the sense that he wants to put all of his money into one basket, but it’s not as conservative as he thinks, because now all of his money is invested in one property and if that property does not do well, he doesn’t have other properties to spread out some of those risks against. And so I’m going to encourage you guys to go take advantage of the visual because it’s helpful to see, but I’m going to walk through some numbers here, right? So Hunter put a down payment of $500,000, and Mike paid 5 million up front. So Hunter ended up taking a loan for 4.5 million at 5%, and the cost of the debt for him was $225,000 over those five years of holding on to that property. You know, they both sell the asset for $5,500,000 so they actually appreciate it, they gain some equity in the process. And what it ends up coming out to is something that’s quite a difference in the actual profit that they receive. So Hunter received a profit of $270,500 and Mike received a profit of 500,000. So they both bought the same property. Hunter put 10% down and Mike put 100% down. Mike didn’t take any debt. Hunter did take on some debt. They both bought the same multifamily property. Hunter buy dollars amount received a lower profit margin.
But what we haven’t talked about yet is the return on his investment — the ROI — the annualized return is a 55% return because Hunter put $500,000 down and was able to receive $270,500 back in profit. Now Mike received only a 10% return on investment but he did receive that $500,000. So, in theory, they both came out in a really strong and really smart investor type way. They’re thinking with that investor mindset, they’re thinking to themselves, hey, how am I going to maximize my return? How am I going to make sure that I’m able to, you know, have my money grow and in time be able to both get — some kind of appreciation is a nice benefit, but they’re both getting some of that cash flow that’s coming in every single day. We’re not even talking about cash flow in this example. But what you’re going to notice is that Hunter, if he was able to spread out that 5 million across 10 other properties at 10% apiece, and he received a 55% return, his overall return is dramatically higher. He just made $2.7 million — roughly.
These are some quick numbers for you guys. But as you can see, the benefits are clear that when things are going well, leverage can really really work to our advantage. That’s why the key thing that Robert Kiyosaki talks about is making sure that you have control and I’m going to get into that in a little bit. But one of the places that you definitely don’t have control is when you’re investing in the stock market. And Kiyosaki goes on to elaborate in his book, again, Financial IQ, I highly recommend you guys to listen to this. I stumbled upon it by accident, but it really opened my eyes to some things and some strategies that, you know, I’m an active real estate investor. I’m learning about the use of money and how to make it work for me even better, and I learned some great things there. But he talks about how risky it is to leverage within the stock market. Because as an investor in the stock market, you don’t have the same levers of control of deciding what is going to actually happen within that property, or what’s going to happen within that business. And you also are not directly selecting who’s in charge of managing the business plan going into it. So what we noticed in the stock market is there’s some huge fluctuations when the economy changes. There’s huge fluctuations when the media drops some kind of news, even if it has nothing to do with the sector or the industry. And there’s huge fluctuations just based on speculation. Some computer trader makes some kind of huge trade and ends up crashing the stock market for the day or locking up computer modified trading. So what ends up happening is that, when we’re investing in a share of Apple — Apple is a great company. It’s probably a company that’s going to continue to grow and it’s going to continue to have great returns. One of the things is we don’t really control what the CEO does. We don’t control how the economy reacts to it. We don’t control how other people’s emotions react to it. And so that ends up creating an environment that we’re not in control of.
However, with real estate, conversely, with a multifamily operator, the property they’re buying is leveraged, but it’s a property that is leveraged that they control. So the bank is putting up 80% of the money and the investor team is putting up 20%. So the management team itself is in control of that asset making those day to day decisions and influencing and ultimately impacting how that business is going to run. They’re in direct control of what’s going to happen. Now, they can’t control if some kind of major economic meltdown happens, and maybe there’s going to be some impact there. They can’t control if a tornado blows through town, but they can control where they buy and they can control whether they buy in areas that have economic disasters or natural disasters and choose to not invest in those areas. Or if they are investing, they can have a plan of action that they are in control of how they’re going to react when that situation happens, right.
And even as the passive investor, you’re thinking to yourself, well as a passive, that’s the whole point is that I’m not in control, but you’re in control of choosing where you’re placing your money and you’re in control of choosing what business plans you invest in, and you’re in control of delegating that responsibility to that manager. And so when you’re able to choose a great manager, and when you’re able to choose the right place or right group to invest in, you’re essentially betting on that group. And so together, you guys are in this. And typically the operator, their income is based directly on the success of that project, so they don’t make any money if the project doesn’t do well. The incentives are aligned dramatically differently than those in some other industries. What does that mean? Well, when we leverage, we end up seeing better returns when we have returns.
There’s obviously some risks that go along with leverage and we can’t ignore those risks and sometimes we want to be extra conservative and maybe take on less debt or buy in areas that end up having a lower risk profile. We want to make sure that we’ve got an operating plan that we can pay our debt and we can run the building well even when there’s vacancies or issues going on. So these are all things that you’re in control of because you’re in control of where it is you’re going to invest, and what that plan is going to be and how you’re going to mitigate any of those risks going in. And as you can see, when we’re able to essentially have a 55% return versus a 10% return, as an investor, whether you’re talking about being active or passive, you’re going to end up benefiting from that return dramatically without taking on all of the risk that goes along with it by signing on the docs if you’re passive, or by investing in the stock market where you really have absolutely no impact or influence over where that’s going to go. So I hope that you guys can see the beneficial use of leverage.
There’s obviously some ways that you want to watch out and make sure that you’re not becoming over levered or you’re not using it in dumb ways. But what I do encourage you to do is continue to educate yourself. One of the biggest ways to gain leverage is by education. The more That you can learn, the more that you can understand the industry and what you’re investing in, the better position you’re going to be to be able to choose great operators, to be able to choose great investments, to be able to choose great properties to go and operate yourself. And so I really encourage you, if you’re looking to learn more, head over to theinvestormindset.com/multifamily to take advantage of all these free resources that we’re putting together, the amazing expert interviews and some of the free training that’s going to be rolling out here over time. And so whether you’re talking about on the active or passive side, multifamily can be a great option. And one of the great things about multifamily and real estate in general is the ability to apply leverage in a smart way as Kiyosaki talks about. So I encourage you to continue to join us every single week as we’re diving in deep to more and more topics on what are the best asset classes to invest in, what are some of the strategies to apply, how do I get my mindset in the right place to make sure that I’m making smart Investing decisions and that I’m staying focused and on track on the things that are going to make a big difference in my life.
And so I encourage you to make sure you hit that subscribe button. Don’t miss the opportunity to get more great resources and free resources from us. And if you loved what we do, we’d be grateful if you’d be open to dropping a five star review wherever it is that you listen to podcasts. Make sure you hit that thumbs up button and drop a comment letting us know how have you used leverage in the past and how has it benefited you and what are some of the things you like to look out for when it comes to using leverage? With that, I’ll leave you as I always leave you to live a life worth inspiring others and you can do so today by applying some of this directly in your life by going out and educating yourself more and learning how you can take your investing career and therefore your ability to reach financial freedom to a whole other level. I will see you guys next time and thank you so much for all your support. I’m grateful to be working with you guys.
[00:14:00] Steven: Thank you for listening to The Investor Mindset podcast. If you like what you heard, make sure to rate, reviews, subscribe and share with a friend. Head over to theinvestormindset.com/multifamily to join the insider club where we share tools and strategies from the top investors and entrepreneurs and how to take it to the next level.