Published August 2001

Leverage, roll-up plans make money work for you

Most investors who develop substantial wealth in real estate do it by letting their equity grow over time. Wealth generation and long-term hold seem to go hand-in-hand with successful real estate investments. But that doesn’t mean you sit on your hands after you buy your first property and wait for good things to happen.

The strategy of rolling up and the benefits of moving your equity and leveraging it into different properties may help position your money to work for you in the most favorable way.

Say you walk into your real estate broker’s office with $300,000 to invest. If apartment properties are selling for $50,000 per unit, for example, you can get into a six-unit complex right now. However, if you use the $300,000 as a down payment to buy a larger property, you can acquire a 20-unit complex if you borrow $700,000 on a $1 million purchase price.

This is the leverage strategy. But the real reason for leveraging — or borrowing someone else’s money to buy “more” — is most evident when it’s time for the first market-driven rent increase.

If the local market suggests rents could go up about $10 per unit per month, your cash flow improves $60 per month if you bought the six-unit with no leverage. If you used some leverage to buy the 20-unit property, your cash flow would improve $200 per month. Quite a difference. That’s the power of leverage in investment real estate.

Now, imagine that as you watch the market you find out that the north end of town is showing more rent growth potential than the neighborhood where your 20-unit is located today. This is when you consider a “roll up” to a property in the more desirable area to take advantage of the better rent-lift potential there. You’re going to effectively move your equity from one property to another, or roll up your equity into the new property.

Under the IRS Section 1031 rules, this type of a transaction is done tax-deferred assuming the purchased property is of greater value than the property you sold and you don’t pull any money out of the transaction.

In any roll-up strategy, you also may want to keep playing the leverage game. Again, you pick up that much more cash flow and corresponding value when the next rent increase kicks in if you go from the 20-units we’ve used in this example to, say, 25 or 30 units on the property you rolled up into.

Overly aggressive leverage-minded investors can become blinded by strong markets, though, and look to put so little money down that they cannot withstand the unexpected — but inevitable — flat or declining market.

A proper degree of caution should be placed on any leverage and roll-up plan, of course. In investment real estate, a good rule of thumb is to put down no less than 25 percent of the property purchase price. Most lenders won’t extend loans at greater than 75 percent of the property value today for this reason, so you’re often limited by the amount you can borrow anyway.

Using sensible leverage and rolling up to keep your equity working for you in the most favorable markets can accelerate the wealth-creating potential of investment real estate. Staying in the game long term is the key, though.

Tom Hoban is CEO of Everett-based Coast Real Estate Services, a property management and real estate advisory company specializing in multi-family and commercial investment properties. He can be contacted by phone at 425-339-3638 or send e-mail to tomhoban@coastmgt.com.

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