Leverage

Key Takeaways

• Leverage means funding part of a purchase with borrowed money so a smaller amount of cash controls a larger asset.
• Leverage multiplies the percentage return on the cash invested in both directions, gains and losses alike.
• A larger down payment lowers leverage, which shrinks both the potential percentage gain and the potential percentage loss.
• In Washington, after a trustee's sale under a deed of trust, a deficiency judgment cannot be obtained on the obligations that deed of trust secured, except as chapter 61.24 RCW permits for commercial loans.

What It Means

Leverage is the use of borrowed money in place of a buyer's own cash to fund an investment. An investor who pays all cash for a building owns it outright and keeps whatever the building earns. An investor who puts 25 percent down and borrows the rest controls the same building with a quarter of the cash, and the return measured on that cash moves four times as fast in either direction.

The mechanism is arithmetic, not magic. Return is measured against the cash the investor put in, so shrinking that cash while the property stays the same size enlarges every percentage that follows. A $40,000 gain on $400,000 of cash is 10 percent. The same $40,000 gain on $100,000 of cash is 40 percent. The identical logic runs downhill: a $40,000 drop takes 40 percent of the leveraged investor's Equity and only 10 percent of the all-cash investor's.

Leverage on a single property is usually described by its Loan To Value Ratio. More borrowing means more leverage and a thinner equity cushion, so a smaller decline in value is enough to erase it, while Appreciation lifts the leveraged owner's equity by a much larger percentage.

How It Works in Washington

Washington does not cap how much leverage an investor may use, but it does shape what happens when leverage goes wrong, and that is the part a licensee has to state correctly. Most Washington loans are secured by a deed of trust, which RCW 61.24.020 allows to be foreclosed by trustee's sale. RCW 61.24.100(1) then provides that, except to the extent the section permits for deeds of trust securing commercial loans, a deficiency judgment shall not be obtained on the obligations secured by a deed of trust against any borrower, grantor, or guarantor after a trustee's sale under that deed of trust.

The practical effect in Washington is that a leveraged borrower whose residential loan is foreclosed by trustee's sale usually loses the property and the equity in it, and no more. Commercial loans are treated differently. RCW 61.24.100(3) permits deficiency actions after a trustee's sale on a commercial loan in defined situations, including actions against a borrower for waste or for wrongful retention of proceeds, judicial or nonjudicial foreclosures of other security, and actions against guarantors. An investor who leverages a commercial purchase, or who personally guarantees the debt, is carrying a different risk from the one a homeowner carries, and that difference belongs in the conversation before the offer is written.

Example

Priya is buying a $400,000 rental duplex and models it two ways. Paying all cash, she invests $400,000. Borrowing instead, she puts 25 percent down, which is $100,000 of her own cash, and finances the remaining $300,000 secured by a Deed Of Trust.

Say the duplex appreciates 10 percent in the first year, to $440,000, a gain of $40,000. On the all-cash purchase that is $40,000 on $400,000 invested, a 10 percent return on her cash. On the leveraged purchase it is $40,000 on $100,000 invested, a 40 percent return. Now run the same year in reverse. A 10 percent decline to $360,000 costs her 10 percent of the cash in the all-cash case but 40 percent of it in the leveraged case, where her equity falls from $100,000 to $60,000. A 25 percent decline to $300,000 leaves the loan balance equal to the value and her equity at zero. These figures set aside loan payments, rent, and closing costs, which is why leverage is judged across a holding period rather than on one line of arithmetic.

Common Mistakes and Exam Traps

• Leverage describes the share of borrowed money in a purchase, not the interest rate charged on it.
• Leverage is not automatically positive. If the property returns less than the cost of the borrowed money, leverage enlarges the loss instead of the gain.
• The loan-to-value ratio measures how much leverage a property carries. It is not itself a measure of return.
• Higher leverage does not spread risk. It concentrates the investor's exposure on a thinner slice of equity.