Finance for Investing in Commercial Real Estate and Mastering Leverage
Finance for Investing in Commercial Real Estate and Mastering Leverage
The use of leverage can greatly increase an investment's profitability. If you invest and manage the money you borrow from a lender well, you can earn interest on both the borrowed and invested funds. Finding projects that will generate more profit than the interest you paid on the loan is the holy grail of commercial real estate investment financing.
To illustrate the point, let's say you can borrow 75% of the amount needed to buy a piece of commercial real estate at an interest rate of 6% per year and the investment yields 9% per year. A 9% yearly return is required for the 25% of the purchase price that you must invest with your own funds; however, you will also get a 9% return on the 75% that you borrowed.
But since you are only paying back 6% of the money you borrowed, your annual profit is 3%. While 3% isn't exactly a windfall, it does allow you to buy more stuff and control more assets when you know how to use leverage correctly. With a $100,000 transaction, 3% isn't much, but with a $3,000,000 deal, it looks considerably better.
Although using leverage can significantly boost an investment's profitability, it also raises the investor's risk exposure. When the return on an investment is lower than the cost of borrowing the money, problems start to emerge. As we saw in the last example, if your investment yielded less than 6% but you borrowed money at 6% per year, you would be losing money and getting a poor or negative return. The most successful real estate investors are well-versed in the financial ins and outs of investing in commercial properties and always have a plan B. Before you use leverage, make sure you can pay back the loan no matter what happens.
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