This is a contributed post from Michael Gray, a real estate investor from California who also invests here in the Philippines.
Leverage is a powerful tool for real estate investing, you just need to know how to use it effectively in order to compound your net monthly cashflow and net worth. I’ll show how in this post…
However, the word “leverage” is one of the most misused, or at least, misunderstood words around investment. This misuse or misunderstanding of the word sometimes leads to inefficiency of investment.
Which is why the first thing we need to do in order to make sure that we are all starting on the same page, is define the terms that were just mentioned: Leverage, Net Monthly Cashflow, and Net Worth.
What is Leverage, Net Monthly Cashflow, and Net Worth?
Leverage, as defined by dictionary.com, is “the use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one’s investment, to control a much larger investment, or to reduce one’s own liability for any loss.”
Investopedia defines it this way: “Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project.”
Here’s a short video from OneMinuteEconomics.com that explains leverage in 1 minute:
The definitions above are pretty similar and they work. They are basically referring to the use of borrowed money to increase wealth.
Notice 2 out of the 3 definitions don’t say “using borrowed money to buy something.” A lot of investors however, and people in general, tend to use “leverage” as if leverage = loan. And that is a mistake.
When we use the word leverage in our discussion, we mean that we are using equity in order to compound our Net Monthly Cashflow and Net Worth.
Net Monthly Cashflow (NMC): When we talk about Net Monthly Cashflow, or NMC, we are talking about the monthly profit (income – all expenses) that a property or portfolio produces.
Net Worth (NW): Net worth is simple. It is the total value of all assets owned, minus all liabilities. Liabilities are things you owe such as remaining mortgage balances, or any other outstanding debt.
Types of Real Estate Investors
Now that we are starting on the same page, we can talk about how to use leverage in order to compound NMC and NW. The first thing you need in order to use leverage is equity.
Equity is the difference of the total value of an asset, minus the remaining balance on the mortgage (what it is worth – what you owe on it). So if you have a house and lot with a value of PhP 2M, and you have a remaining balance of 500k on your mortgage, then your equity is 1.5M.
If you are starting with zero equity, then there are many ways to get some, which we will get to further down.
There are three different categories of investors.
- Capital Appreciation Investors (buy low, sell high, pocket the profit),
- Cashflow Investors (Invest in assets that produce regular income),
- and those who are doing both, or Hybrid Investors.
A good example of Capital Appreciation Investors are house flippers. House flippers buy a property for well under market value, then increase the value of the property through renovation, then they sell the property and pocket the profit.
A Cashflow Investor example, on the other hand, would be one who invests in rental real estate, in this case, or any other asset that brings regular income to the owner. Rent or lease payments are the income in our example.
There is nothing right or wrong—good or bad about being either one. You can make very good money with either or both ways.
There is plenty of room for a hybrid situation as well. A sophisticated investor is flexible and open to using whatever process will work in any particular investment situation.
Speaking of process, let’s take a look at both processes and see where leverage fits in. The goal from both perspectives is very similar. In fact, it is exactly the same until the final step.
What Real Estate To Look For?
In either process (flipping/cashflow), we are looking for a house that has a problem or an issue that is severely affecting its current market value.
This could be cosmetic, if it is old and rundown-looking, if it is in desperate need of repair, if the yard is overgrown and it has no curb appeal, or if there is an issue with paperwork, survey, and/or title.
Whatever the problem or issue is, it MUST be one that we can solve reasonably efficiently (reasonable cost and timeline), and it also has to be definite, meaning it will definitely increase the value much higher than the cost of the improvement.
So, this removes something like potential value increase when a new expressway is proposed to be built, or something that would be nice if it happened like a rise in property values, or has been talked about happening but may potentially be well in the future.
That is not investment, it is speculation!
It is not always bad to speculate. Warren Buffett says that we should have no more than 25% of our investment portfolio in speculation. However, we are talking about sure investments here—not speculation.
The Real Estate Investing Process
Both the cashflow investor and house flipper are looking for similar properties. Intelligent house flippers will always make sure that in the event that they are forced to hold onto the property unexpectedly, it would rent for enough to generate a positive NMC.
Cashflow investors do the same thing, except it is their main focus rather than their last resort. The only difference between them is what generating a positive NMC entails. It generally depends on how much the loan payment and rents are.
However, both types of investors could have paid cash for both the property and renovation, at which point there would be no loan payment.
In those cases, the only monthly expenses would be competent property management, repairs and maintenance, any utilities that you have agreed to pay for the tenant—if any, and taxes.
These are all negligible expenses that are easy to cover with rental income. The big expenses are loan payments. So, we must focus on properties or areas that have high enough market rents to cover those, plus a little profit.
So far, the strategies are exactly the same. Find a property that is well under market value, and increase the value of said property with renovation and/or by solving an issue.
Capital Appreciation Investors
Then, the house flipper (capital appreciation investors) can sell the property around market value and pocket the profit of the sale.
Generally speaking, after any discount from market value to sell it faster, or negotiated selling price, Capital Gains Tax (CGT), Documentary Stamps Tax (DST), Transfer Tax, Registration Fees … etc. that you agree to pay, and professional fees for a Realtor (if you use one), you are looking at around 80% of the market value—on average.
This 80% that is brought in is then used to pay off any loans taken out for buying/renovating, then the remainder is used to buy and renovate/solve the issue of the next property. And anything leftover is our profit from the last deal.
This cycle can be repeated indefinitely, as long as you make profit with each deal—meaning completing proper due diligence is the most important part, so you can reduce/eliminate the risk of not making money.
The Cashflow Investor does not sell in the last step. Instead, he or she will find a tenant for the property and start generating a Net Monthly Cashflow.
A lot of investors and would-be investors raise a valid point. They say that “if one buys a property, then rents it out, it would take a really long time to use the saved NMC to buy and renovate the next property.
Whereas with flipping, you have the cash for the next deal in your pocket already. So, Cash Flow investment is a very slow investment vehicle.”
This statement is absolutely true and correct. It is a very slow strategy to save up the NMC to buy and renovate the second property—probably years. So, since we are not interested in waiting years before the next investment, what should we do?
What if there was a way that we could keep the asset, keep the NMC, and still immediately move to the next investment, without taking any more cash out of our pocket?
You would be waiting for the “catch,” or, you would likely be at least waiting for some sort of sales pitch for an investment program. There is none of that here.
The Power of Leverage
There is an easy way, and it is called leverage. This is how it works:
Once our property is rented out, we have a rental property producing cashflow each month. This property is freshly renovated and worth the same as the house flipper’s.
The house flipper, on the other hand, has around 80% of the total market value after the sale, taxes, and fees, that they can fund their next deal with—after any loans from the last deal are repaid.
Leverage allows you to get that same 80% (sometimes as much as 90%) of the market value, tax-free, to buy and renovate the next property. And, you get to continue to receive the NMC each month, though the cost of the leverage will reduce that NMC a bit for a while.
Since you own the property free and clear, the total equity = Fair Market Value. So, what is Fair Market Value (FMV)?
It is quite simply, “the price of a property or object that a knowledgeable buyer and seller agree upon, in an unforced transaction that takes place in an open marketplace.” That is, the current value of the property right now. Banks use appraisers to estimate this value—the appraised value.
Our leverage, in this case, is a cash-out refinance (or a home equity loan). A few banks will lend up to 90% of the total appraised value in a cash-out refinance, but almost all of them will loan 80%. Notice that the 80% of the appraised value is similar to the average amount pocketed by the flipper.
There are some differences, of course. It is tax free because it not income, capital gains, or profit—it is a loan. This loan is actually repaid by our tenant in the form of monthly rental payments.
This leverage will reduce the NMC of the property by the mortgage payment amount until the loan is paid in full.
However, if we do our proper due diligence the way Jay outlines in his course, then we will be only interested in those properties that will provide a positive NMC after they are leveraged.
Also, when we analyze the After Repair Value (ARV) during our due diligence, we only pursue properties of which the leverage proceeds will be well above what it costs to buy/renovate/solve the issue of the next investment.
This leftover cash is basically our profit (though it is technically loan proceeds). We can use it in any way we choose. We can use it to pay for living expenses, go on a vacation, buy a luxury, or reinvest it.
Once there is a tenant is in place on our property, we have created a stream of income that will continue to finance the next deal indefinitely. So, we have created an infinite stream of properties that will continuously grow our NMC and NW forever… Just keep repeating the process.
This is linear growth. Each successful deal in the stream pays for the next deal in the same stream—growing our income, net worth, and net monthly income with each completed deal. It is like a straight line. One finishes, then the next starts, when that one finishes, the next starts, and so on. Sound’s like the BRRRR investing strategy…
The BRRRR investing strategy
This strategy or process is commonly referred to as the Buy, Renovate, Rent, Refinance, Repeat method or “BRRRR” method. When we start with the BRRRR method and add leverage, we get compounding.
BRRRR is linear growth, which is good, but nowhere near as good as compounding. Linear growth gains are measured in percentages (20%, 40%, 100%). Compounding gains are measured in orders of magnitude (10x, 20x, 100x).
So, Let’s Talk About Compounding
When we talk about compounding, we mean exponential growth—not linear. The way that we start really compounding is by starting another stream of properties to go with the one we have already established. How can we do this? Good question. Let’s talk about that.
In order to begin compounding both Net Worth, and NMC, we can use some or all of the aforementioned leftover leverage proceeds to make a principal payment on our oldest mortgage. If we do this for each deal, we will pay off our first leverage very quickly.
Keep in mind: In order to be efficient, this means we must acquire leverage with little or no prepayment penalty.
When we pay that first leverage off, we have two choices. We can either increase our NMC by the amount that the mortgage payments were before we paid off the leverage, or we can leverage it again and start another stream—beginning the compounding.
Here’s an example: We will use the same example as we used in ROI—Flipping Vs Rentals: Let’s say that we have PhP 500k to invest (regardless of how we got it). Since we are intelligent investors, we decide to start small and buy a foreclosure from BFS.
We are looking for a house with an After Repair Value (ARV) around 1 million pesos in an area with market rent at 12k-15k/month (this is a goal, but not a hard line. If rent is less, then it will lower our NMC, which is okay as long as it remains positive).
We find one that needs renovation in order to reach that 1M value. Current appraised value is 700k, but it is for sale slightly under current market value, at 670k.
Since we are buying from BFS, we know that we can get a 40% discount for paying all cash, so we buy it at PhP 402,000. After the 98,000 of renovation is put into the property, it is appraised at the 1M goal. It is then rented out at the market rate of 12-15k/month.
We do a cash-out refinance at 80% for 20 years, which will put 800k of proceeds into our pocket. This would come at a monthly payment of about PhP 5,731.45 at 6% interest. So, our monthly cashflow, on the low end, would be PHP12k – PHP5,731.45 = PHP6,268/month. On the high end, PHP15k – PHP5,731.45 = PHP9,268.
Out of that PHP800k, we set aside PHP500k to repeat the initial process with, and have PHP300k leftover. We put PHP100k in our pocket and make a PHP200k principal payment on the PHP800k leverage—reducing the outstanding balance to PHP600k.
After only four deals, our first leverage is paid in full. At that point, we have one stream of properties that will continue growing—indefinitely.
So, we take that PHP500k that we set aside to repeat the process and start another stream of properties by buying and renovating a deal similar to our first one, then repeating the exact same process that we followed with the first stream.
Each stream pays off another “refi” with every fourth deal, and can be re-leveraged to start a new stream. This compounds our net worth and NMC exponentially, and remember that it all started with that initial PHP500k—no further investment was required.
I generally like to leverage each of the first five properties in a stream two times. Everything past that, I just take the increase in monthly income and leverage as needed.
This is because even though I have an assistant, it gets difficult to manage so many deals each month. It is a nice problem to have, but this system is like a freight train with no brakes—running on an infinite track.
It is difficult to stop once it gets going. Once the deals are taking too much time to keep up with, you can start using the available equity to buy bigger properties, like duplexes, triplexes, quadplexes, or apartments, which will significantly increase both our NMC and NW.
It cannot be emphasized strongly enough, that we make money when we buy. This means that our analysis and due diligence are the most important things we do in real estate investment. There is risk in every investment. Proper Due diligence significantly reduces the risk to almost nothing.
So, how do you get started? This depends on your current situation. If you have investment capital saved, that’s the ideal situation. If you already have enough equity in your current house, or property that you own, that is the second-best situation.
If you have neither of those, then you can flip a few houses, which will get you through the process of finding, analyzing, negotiating, buying, renovating, and selling properties for a profit. Remember, the process is the same for both types of investment.
Another great way to start out is to partner with someone you can trust. If you both put in capital, then you could form an entity that does your investing. With your portion of the profit, you can then start your own private stream and go from there.
Find a Mentor
If you have enough capital, but lack the experience and are concerned about going it alone, then you can try to find a mentor. Someone who has plenty of experience—been through the process at least several times. Most successful real estate investors are happy to spread the knowledge around.
Most successful real estate investors are also usually pretty busy, and their time is valuable. Further, each person is different and has different wants and needs. It has to be worth their while to mentor you. Keep that in mind when asking a person to mentor you.
I am not suggesting that you offer to pay him or her, because they would probably laugh at that, but offer something in return and remain humble. Robert Kiyosaki tells the story about when he was asking someone to mentor him, after he was already a successful investor.
He went to the man and said: “I want to learn from you, so I am willing to work for you and do whatever you need me to do, and I’ll do it for free.”
This surprised the man, so it took a few times of visiting with him to get a response. Finally, the guy called him back and said, “You want to learn from me, and you want to work for me for free and do anything I need?” Robert said absolutely.
So the man told him okay, fly across the world and analyze this investment I am considering investing in. I think it was a diamond or gold mine. He did not offer any salary, payment or stipend for travel or anything. Robert paid for everything, which likely cost over PhP 500,000 alone.
And from then on, he learned so much and was able to compound his wealth further from that mentorship. This is just an example of how Robert brought value to the potential mentor. The point is that it has to work for both people—a win-win situation.
Finding a Deal
Once we know where our investment capital is going to come from, it is time to start looking for deals. This site is an excellent place to find potential investment properties that are under market value, but not all of them are, so proper due diligence is crucial. Further, a lot of these foreclosed properties have problems that are easily solvable.
There are plenty of places to find deals. There are plenty of scams as well, so always do your due diligence thoroughly and you will almost always be safe from scammers.
Also, “inspect what you expect.” Verify that the seller is the actual owner or has the right to sell the property, and that they are who they say that they are.
The 100:10:3:1 rule starts over with each property. This means that for every investment, you must look at 100 properties. Of those 100 properties, you will find 10 with potential and worth further investigation.
Of those 10, you will start your due diligence and negotiate on three. Of those three, there will likely be one that everything comes together, the offer is accepted, and you buy the property.
Start Practicing Right Now
Even if you do not have the capital or equity to invest right away, you should get in the habit of trying to find the next “Deal of the Decade.” As Dolf de Roos frequently says, “the deal of the decade comes around about once per week.”
Start finding, analyzing, and practicing due diligence as soon as you can, so that when you are ready to start, you have some experience already. Also, chat, talk, and spend time with like-minded people. It is much easier to learn together, than alone.
The Philippines is the new land of opportunity and it is ready to make a serious rise. There is no shortage of great deals here. They are everywhere—that is why I came here. You just have to look for them, and know what you’re looking for.
If you do not yet know how to find and analyze potential investments, I highly recommend Jay’s course.
When I came to the Philippines, I knew that all of my experience, trial and error, and developing my strategy in the US, mean absolutely nothing here.
I needed to learn some things immediately, and since learning is a lifelong process, I am always doing it. I didn’t want to spend the next few years figuring things out. So, I started looking for a good course. I looked at several courses and chose Jay’s.
All I wanted to know, was how to find good potential investments here, how to analyze properties here, how to determine renovation costs, and how I can get access to leverage. Also, the process and fees involved in buying, selling, and managing properties here.
I learned all of that and more in Jay’s course, and that is why I’m donating these articles to help him help Filipinos gain their financial independence, and become sophisticated investors.
Feel free to leave any comments or questions below and Jay will get them to me. I will try to answer questions as soon as I can.
Tagged with: brrrr, cashflow, flipping properties, investing for capital gains, Leverage, Net worth, Real Estate Investing, rental property investing