In the land of the illiquid investment, cash is king. After 2008 lending institutions severely tighten their underwriting standards, requiring 20%+ down payments for investment properties. 20% down makes even the smallest investment a capital intensive endeavor. Buying a $100,000 property now takes $20,000 in cash. Not a small sum for many first time investors. What makes real estate even more challenging is the fact that the $20,000 investment will be tied up for the next two years (minimum) and cannot be used for any other down payments.

For many novice investors, this proves to be a significant barrier to entry and puts a hefty premium on success. However, even by putting 20% into an investment, real estate still remains one of the highest leveraged investments many individuals will make. This leverage provides the power behind investment returns in real estate. Let’s demonstrate this with an example.

Assume an investor puts $20,000 down on a property worth $100,000. Next, let’s assume the property appreciates 5% in the first year and the investor sells the property. For ease of explanation, let’s assume no selling costs. Upon selling the property, which is now worth $105,000 after the 5% appreciation, the investor pays off the $80,000 and receives $25,000. In one year, the investor turned $20,000 into $25,000, a 25% return, based on an appreciation rate of only 5%.

This is the lure of leverage. A great way to work with friends and family, who want to invest in real estate, is to promise a fixed return plus some return of principal. Consider a stable property selling for $100,000 with a market rent of $700. Rather than putting $20,000 down to secure the property, an investor might consider raising $10,000 from friends and family by promising them a yearly return of 10%, much better than a return they might get in a saving account. Again, let’s assume in the first year the investment appreciates 5% and the investor sells the property. Now the investor pays of the mortgage of $80,000, plus the friends and family loan of $10,000 and keeps the remaining $15,000. After subtracting the $1,000 additional interest payment, the investor is left with $14,000 or a return of 40%.

Importantly, leverage works both ways. While it magnifies gains, it also magnifies losses. Using the same examples above, if the property lost 5% of its value the returns would be highly negative. Leverage provides an excellent tool to stretch investable income and to boost returns, but it also adds to the risk of the investment and costs money in the form of high interest rates. All investors should take care to understand the cost of any financing they employ in their real estate investments.