What is Equity Leverage?
Equity Leverage is an idea that Cash Flow Net Worth coined.
The concept of leverage is one that people understand. Leverage is effectively placing debt on an asset. The concept of leveraged equity is one that people know and understand. Leveraged equity is effectively that the returns from an interest in an entity are enhanced through the use of leverage or debt financing.
Leverage and leveraged equity have to do with debt. Equity Leverage is two pronged in that your equity investment is leveraged by the debt financing at the property level and your equity is also leveraged by investing a smaller amount of equity in each deal alongside other equity investors, which means that you can do larger deals with more economic scale than you may be able to do on your own otherwise.
Equity Leverage is a huge concept once it is fully understood. It is a concept that many people do not really think about, but they should. In many asset classes, size and scale matter. The counter to this is with single tenant net lease deals and with apartment complexes because there is a lot of money that also chases those two asset classes. But in general, size and scale can mean faster value creation. When rents increase in a given market and/or when the value of a property on a price per square foot increases, the larger the size of the project, the more quickly those increases in revenue and value are realized at the property level and for the investors.
The concept of Equity Leverage gives you the ability to diversify your net worth among a number of deals. Most investors think in terms of owning a property outright by themselves. However, that defeats the purpose of the Equity Leverage Method. First, by using your capital in one property that you are the sole owner of, you benefit from all of the upside in that property, but continually buying properties outright limit the amount of investments that you can make. Second, by using your capital in one property, you are not getting the benefit of investing in multiple larger deals with the same amount of capital where arguably your cash flow and net worth would increase at a faster rate.
Equity Leverage can usually be achieved best in Funds, crowdfunded investments, and friends and family investments. With a Fund, the Sponsor is pooling a large amount of investor funds, and then investing those funds across a wide range of properties and geographic locations. With crowdfunded investments, the Sponsor is pooling a large amount of investor funds, and typically investing those funds into a single asset. With friends and family investments, the Sponsor is pooling a large amount of investor funds, and typically investing those funds into a single asset.
Why Implement the Equity Leverage Method?
The Equity Leverage Method is a strategic tool. It is effective, but it does not have to be the only strategy you implement. If fact, I view the Equity Leverage Method as another strategic arrow in the quiver. Equity Leverage is a sexy and sophisticated method to obtain additional diversification, to invest in larger deals, and to utilize compounding through both leverage and leveraged equity.
Diversification is that having a variety of investments will shield you from unwanted exposure to a particular area. Through real estate investing, it is possible to diversify in four primary ways. As an investor, real estate enables you to diversify by investing in different real estate asset classes (e.g. apartments, office, industrial, retail, leisure, self-storage, etc.), in multiple geographic markets, with a variety of real estate Sponsors, and through exposure to different currencies.
By spreading your investment capital and net worth around to multiple deals in various asset types in different locations with multiple Sponsors and potentially in a variety of foreign currencies, you can achieve further diversification with the Equity Leverage Method.
Economies of scale is defined as the cost advantages that enterprises obtain due to their scale of operation. You can also achieve scale by utilizing the Equity Leverage Method. This is due to the fact that your equity does the scaling for you. You are able to put smaller amounts of money to work in a larger number of deals. By putting smaller amounts of capital in more deals, you spread your risk around and you also are able to invest in organizations and deals that are achieving economies of scale on the behalf of the investors.
Scale can be achieved by going deep in a certain asset class or a certain geography. However, scale can also be achieved through investing strategies. Cash Flow net worth utilizes the Equity Leverage Method to achieve scale and diversification throughout the country by co-investing in deals with our limited investors and by co-investing with other Sponsors in markets that we do not operate in.
Compounding is the computing of interest calculated on the initial principal, which also includes all of the accumulated interest from previous periods. Compound interest is can also be thought of as earning interest on interest. Compounding is a method that the wealthy have used and continue to use to grow their wealth for centuries.
Albert Einstein called compound interest the 8th wonder of the world.
Charlie Munger once said, “Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.”
Benjamin Franklin called compound interest the stone that will turn lead into gold.
Over time, compound interest has a multiplier effect on both your cash flow and on your net worth. But getting to the place where the multiplier effect works best takes time, patience, and good investment decisions.
One example that differentiates the concept of the time value of money and compound interest is the question of whether you would have $1,000,000 today or a penny today that doubles every day for 30 days. From a time value of money standpoint, having $1,000,000 today is better. However, if you can truly double a penny over a 30-day period, you would have $5,368,709.12 at the end of the 30-day period. Clearly, this is a cartoonish example, but it aptly demonstrates the power of compound interest.
Now let’s think about compound interest over a 30-year horizon and let’s assume you can double your money through cash flow and appreciation every 5 years on average. To use a simple example, let’s say that you start with $50,000, you should be able to double your money 6 times during that time horizon. We will assume two additional variables – the first is that you are able to reinvest the money earned into equally attractive deals over the 30-year horizon and the second is that there will be no taxes calculated for our purposes. In the first year, you invest your $50,000.
Start – Invest $50,000
End of 5 years – Get back your $50,000 + $50,000 of profit; Reinvest $100,000
End of 10 years – Get back your $100,000 + $100,000 of profit; Reinvest $200,000
End of 15 years – Get back your $200,000 + $200,000 of profit; Reinvest $400,000
End of 20 years – Get back your $400,000 + $400,000 of profit; Reinvest $800,000
End of 25 years – Get back your $800,000 + $8000,000 of profit; Reinvest $1,600,000
End of 30 years – Get back your $1,600,000 + $1,600,000 of profit; Now you have a nest egg of $3,200,000.
Obviously, these returns are not guaranteed, but they are achievable with real estate. You have to look at your risk tolerance and your long-term goals. But wealth can be created passively through real estate with access to good investment opportunities and with a combination of diversification, scale, and compound interest.
Frankly, we have some deals that have more than quadrupled, we have a number of deals that have doubled, and we have a few deals that somewhat increased. At this point, I have not lost money on real estate, however, I have broken even on two deals where the cash flow and profit effectively got me back my initial equity. Because of this fact, I am a firm believer in the Equity Leverage Method. The method is an important aspect that guides us in our decision making related to real estate investing, and it is a concept that I would wholeheartedly advise you to adopt in your real estate investing career.
Why the Equity Leverage Method Works
There are a few reasons why the Equity Leverage Method works well for me. The first reason that equity leverage works for me is that I am conservative by nature. I want to have dispersion of risk, which means that I would rather spread my investment money and net worth around multiple deals in different asset classes, in different geographies, with different Sponsors, and in different currencies.
The second reason that equity leverage works for me is that I want to be able achieve scale through my investments. I can reasonably do that with my multi-pronged approach to real estate investing, which includes both direct investing, indirect investing, and debt investing. I consistently want to earn money on the money I invest, and I have a better chance of consistent earnings by having my investment capital spread out over a number or investments.
The final reason that equity leverage works for me is that the concept enables me to supercharge my compounding. Not only is the property leverage to leverage the investor group’s equity, but the added effect of equity leverage is that each of the investor’s are leveraging their equity off of each other to get into larger deals with more opportunities to scale.
What am I Recommending?
At this point in time, I recommend that you invest broadly. I recommend that you spread your investment dollars over a number of good ideas, strategies, and investments. I recommend that you utilize the 3-pronged Methodology that we use to make sound investment decisions. And I recommend that you really focus on the Equity Leverage Method because this is an important technique that can help you grow your cash flow and net worth much more quickly in safer investments with a group of likeminded investors and professional, trustworthy Sponsors.
Equity Leverage is all about co-investing, but I do recommend that you diversify by investing directly on your own and that you invest indirectly with people that you know and trust, and who can help you achieve both scale and equity leverage.
I want to preserve the capital I invest. I want diversification. I want access to and the ability to invest in larger deals that can provide scale for my equity. And I want to obtain compound interest over time. These concepts are the magic behind the Equity Leverage Method.
The Equity Leverage Method is powerful. It helps you more safely grow your passive real estate investments in a diversified way with high quality deals with reputable Sponsors.
My exercise for you is to formulate what ways you can utilize the Equity Leverage Model in your own investment thesis. Do you know or can you get introduced to a Sponsor who you may be able to invest with? Can you determine which asset types and/or geographies that you believe have strong growth prospects that you could invest in? Can you think about deals where you could leverage your equity with other investors to invest in a larger deal where your potential for profit also increases?
Ultimately, you are the creator of your own investment thesis, but we hope that you have benefitted from learning about our Equity Leverage Method. We believe that it is a powerful concept that truly aids passive cash flow investors with attaining both increased cash flow and net worth.
Until next time, happy investing!
— Robert Newstead