Wanna have fun at HappyHour? Pose the question to a buncha real estate types, ‘What is leverage?’ It’s possibly the most misunderstood principle in real estate investing.

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Transcript:   Everybody wants leverage, and leverage, as we all know, is little or no down payment; the smaller down payment, the better the leverage. Then they get all old school stories on me with how to move rocks with big sticks, and etc. At best, that’s a secondary definition. Whether you put 5% down, no down, or 50% down, that’s not the primary leverage that is going to necessarily dictate whether you succeed or fail, long term, in that investment. It’s not about down payment. It’s about the cost of your money versus the yield of your investment. Whether you put zero down or 90% down, if the cost of your money exceeds the ultimate yield on your investment, you just had what we call negative leverage. So the guy that puts zero down and loses money, because his cost of money was 6% overall and his return was 5%, that’s negative leverage. He loses, and yet he had zero down and he brags about it all the time. The guy next door to him that bought the same property down the road had 20, 30, 35% down. The cost of his money might have been the same 6%, and somehow—through management, or the fact that he rehabbed it better, or maybe it was just a next door neighborhood a little bit better—his return was 8%, he had positive leverage. Neither return had much to do with down payment. Now sometimes that’s not the case. Sometimes that extra 10 or 15% down actually makes the yield go up. Well, duh, that’s a Captain Obvious thing, right? But typically, the long term, do-it-yourself investor will rely on the size of the down payment to indicate to them whether they have sufficient and helpful leverage or not. We need to look at what’s the cost of my money. Let’s do a quick example. So you’re going to buy something for $100,000, and you’re going to put $25,000 down. You’re going to borrow $75,000 at 5%. Well, if your cash-on-cash is 5-7%, let’s call it 6%, you have positive leverage. If down the road, you sold that and for whatever reason, we won’t talk about why just now, but for whatever reason, you got back a whole lot than you put in, which was $25,000 plus whatever closing costs you got, not the $100,000 you paid for it. So let’s say in 5 years you were making a 6% cash-on-cash cash flow, and your cost of money was 5. When you sold it, you got your $25,000 back plus another $2,000 you put in closing, and you made another 20. Well you got your $27,000 back and another $20,000. So you made way more than your 6% cash flow yield alone. That’s positive. You have to understand that when you talk leverage, the only thing that matters to you, in the end game is if your cost of money is less than the money you’re making on that investment, the yield. If that’s not the case, all the other definitions become irrelevant.