You often hear from real estate agents and investors that owning property is a great investment because it allows one to use leverage.
Leverage, if implemented correctly, can make you a lot of money. But, it is important to note, not all leverage is created equal. Lower risk leverage can make anyone wealthy over the long term and will almost always outperform other real estate investments.
Types of Leverage
The standard leverage types you see in the Greater Los Angeles real estate market are the following:
- The standardized home loan used by homeowners
- Hard money loans generally used by flippers
- Construction loans used by spec developers
The Standard Home Mortgage
The 30-year fixed loan is the most used leverage by home buyers. The goal here is to own a home over the long term, pay down debt, and let the magic of appreciation from low supply and natural inflation work in your favor.
Of course, there is still risk in this situation. Risk of losing your job, bad economy, or even getting sick and unable to earn a living to pay the mortgage.
That said, with a good down payment, solid financials, and keeping track of your budget, the 30-year mortgage leverage remains very low risk and has great long-term wealth strategy.
Hard Money Loans
Hard money loans are quick and easy money at two to three times the rate of a typical 30-year mortgage. These loans are made by sophisticated real estate people who oftentimes, are former investors or agents. Borrowers often are flippers or investors taking on more risk than what traditional lenders can stomach.
These loans are used to get wealth quickly. Find an underpriced property that needs work, add value by fixing it up, and sell for a profit. If a flipper were to use their own cash without a loan on a flip, then their ROI might be underwhelming. If they are to use hard money leverage, even at the expensive interest, their ROI is normally significantly higher.
Of course, the risk grows with flipping and hard money. Properties in rough condition could have hidden expenses, former tenants may refuse to move, the market could go down, etc. If it cannot be sold, then most likely, there is no plan B to rent the property, as the hard money interest exceeds the rental income.
Construction Loans
These can be considered the riskiest loans out there today. Oftentimes, you will see lenders loaning more than the value of the lot purchased. This is what is known as loan to cost, which is not only the investor’s cost of the lot, but also the cost of construction for a new home. Construction loans carry some of the highest risk as new construction properties are the most expensive to build, take time, and tend to get hurt the most in a soft market.
My Favorite Low Risk “Leverage”
By far, my favorite type of leverage is the title’s namesake: Highest and Best Use Investing.
What do I mean by that? Let me try to explain…
In the appraisal and real estate investment world, properties can have a higher and better use. For example…
- A property with higher and better use is a small beach bungalow that exists on a lot that can support a 4,000 sq. ft. home.
- A duplex on a lot that can support three town homes.
- A small restaurant on a lot that can hold a 30-room hotel.
There are properties that exist at highest and best use already. For example…
- A 5,000 sq. ft. home in a residential district allowing no bigger than 4,000 sq. ft.
- A 10-unit apartment building on a lot zoned for two town homes.
- A fast food restaurant with a billboard on the property where the city has put a freeze on any new restaurants and billboard permits.
Now, let me give you examples of a property with a higher and better use versus a property that is at highest and best use.
North Redondo Three-on-a-lot Town Homes
Currently at Highest and Best Use
If you were to purchase a brand new three-on-a-lot town home in North Redondo, it might cost you around $1,200,000.
Real estate tends to appreciate with the market over the long term. If you assume that North Redondo town homes appreciate 5% annually, then after 20 years, that town home is worth almost $3,184,000. This would be a gain of $1,984,000.
Has a Higher and Better Use
Funny thing about North Redondo, there are bungalows and small duplexes that support three town homes selling around $1,200,000.
Over the long term, this property is NOT going to be valued on the $1,200,000 acquisition price, but on the highest and best use price.
Today, three town homes are worth $3,600,000. If you take the same assumption of town homes appreciating 5% annually over 20 years, then those town homes are worth about $9,550,000.
Most three-on-a-lot projects cost developers about $1,500,000 today. If construction costs grew by 5% annually over that same period, then it would cost $3,980,000 to build down the road.
What to Learn from This
That profit gain of the property with highest and best use potential is more than double for the exact same purchase in the exact same area with the exact same appreciation assumption.
The difference? Using the leverage of higher and best use to your advantage.
Over time, properties with higher and better use appreciate at their highest and best use value. It is an invisible form of leverage, not from the bank, but leveraging a smart land purchase to your advantage.
I believe this leverage is low risk because you are not paying the bank interest for this right.
Also, you don’t have to be a developer to do this. In 20 years, you can sell the property for land value and still make $1,000,000 more than buying the town home at highest and best use.
Conclusion
If you have time, you should be hunting for real estate with a higher and best use. Not only can you utilize bank leverage in the purchase, but the “invisible leverage” you have from appreciation is a powerful force. These forces can make just about anyone extremely wealthy without taking on a huge amount of risk.