The use of leverage in real estate investing is a tried-and-true tactic for boosting financial returns. For most investors, leverage comes in the form of a mortgage – you make a down payment for 25% of the purchase price and borrow the rest. Leverage has many advantages, but also some notable downsides.
Why Not Buy a Property in All Cash?
If you have access to a lot of capital, you could buy a $1 million investment property with $1 million in cash. But most investors – especially the savviest deal-makers – prefer to take advantage of leverage. It’s a way to magnify your purchasing power. Instead of buying one property for $1 million, you could make $250,000 down payments on four properties worth $1 million each, and then reap the benefits of owning a larger portfolio. In contrast to tying up all of your cash in one property, leverage helps you diversify your holdings while also amplifying your returns. Or an investor could use the $1 million in capital to buy a $4 million property. Either way, leverage helps you get more bang for your buck.
What is Leverage in Real Estate Investing?
In the physical world, a lever is a tool that allows you to lift a heavier load than you could without the use of leverage. In the financial world, the same concept applies – leverage lets you combine your cash with other people’s money to buy a larger property than you could purchase with cash alone. An investor pays interest on the loan, but the cash flow from the property typically covers the added expense. The real payoff comes when an investor exits the property. Say the $1 million property doubles in value to $2 million. The investor who paid $1 million in cash enjoys a healthy payday of $1 million on a $1 million investment. But the investor whose outlay was just a $250,000 down payment also reaps a $1 million profit on a much smaller investment.
How to Calculate Leverage?
Leverage can be expressed as a loan-to-value (LTV) ratio. Back to the example of the $1 million property, a $750,000 loan would equate to an LTV of 75%. If an investor managed to procure the property with just 5% or 10% down, the LTV would be 90% or 95%.
Here’s how two leverage scenarios could affect returns:
- No leverage: On the $1,000,000 rental property, assume annual pre-tax cash flow of $125,000 and annual operating expenses of $50,000, for gross annual income of $75,000. The cash-on-cash return would be $75,000 pre-tax cash flow / $1 million invested, or 7.5%.
- Standard leverage: Say you take out a $750,000 mortgage, and the debt service boosts your annual operating expenses to $100,000, thereby reducing your gross annual income to $25,000. The cash-on-cash return rises to $25,000 pre-tax cash flow / $250,000 invested, or 10%.
Ways to Access Leverage in Real Estate
Leverage means using some of your own money and a lot of other people’s money to finance your real estate investments. Funding for real estate projects is readily available – largely because the underlying property acts as collateral. If you fail to live up to your end of the leverage bargain, the lender or investor can seize the property. There are a variety of points in the financing system where investors can gain access to leverage, including:
- Taking a mortgage from a bank or credit union.
- Applying for a loan through a mortgage broker.
- Borrowing from a private money or hard money lender.
- Partnering with other real estate investors by forming a joint venture or a limited liability company.
Interest rates, loan fees and other terms and conditions vary from lender to lender. Qualifying for financing will require you to meet the lender’s requirements for credit score, debt-to-income ratio and cash reserves.
How To Leverage Debt in Real Estate?
If you borrow money to buy property, you’re using leverage in real estate. Homeowners are familiar with this scenario – they can’t afford a $500,000 house, but they can afford a $100,000 down payment, so they borrow the rest. Many real estate investors use leverage as a strategy to increase their profits and net worth.
How to Increase Your Real Estate Net Worth With Leveraging
A major advantage of leverage is that it lets you reap larger returns. Here’s one example: Say you use $250,000 of your own cash and a $750,000 mortgage to buy a $1 million property. If the property appreciates to $1.2 million, or $1.4 million, that extra equity is yours. You still owe the $750,000 loan amount, but the additional value is yours.
Avoiding Leveraging Risks
Leverage in real estate can is a smart way to boost returns. But this powerful tool can backfire in some instances. If property values plunge, or if your property doesn’t produce the cash flow you anticipated, you can find yourself in default. While the wealthiest and most powerful real estate investors can keep their properties even through default, small investors who can’t repay their mortgages can and do lose their investment properties in foreclosure proceedings. During the Great Recession, as property values plummeted, many investors defaulted on their loans and lost their assets in foreclosure. The Covid-19 pandemic served as another reminder that unexpected crises can interrupt investors’ cash flow. Another risk comes from paying hefty interest rates for the privilege of using other people’s money. If you have no choice but to use hard money or private money, make sure you have an exit strategy. That might entail selling the property and paying off the loan, or refinancing at some point into a leverage situation with more favorable terms.
How Much Leverage is Recommended?
An investor who uses no leverage leaves money on the table. By contrast, an investor with too much leverage runs the risk of being “upside down” – meaning that, in a downturn, the debt on the property exceeds its market value. An owner in this situation is more susceptible to a default. In the middle ground, an investor who deploys leverage carefully is better positioned to sit out a downturn and wait for the real estate economy to recover. While there’s no magic number, it’s worth noting that most lenders require a down payment of 20% to 25% down, depending on the borrower’s credit score and risk profile. That seems to be a range that strikes a balance between too much leverage and not enough.