Understanding Leverage in Real Estate
Written on October 26, 2023 by Scott Gibson
Do you want to maximize real estate investment returns, diversify your portfolio, and build wealth? The secret is to use leverage in real estate investing.
Leverage is a valuable tool that uses other people’s money to buy property. This strategy allows you to find more lucrative investment opportunities while protecting your liquid assets. It gives you endless possibilities to purchase real estate with little or no money down.
Real estate investment is popular because of its potential for high returns. However, the concept of leverage can be tricky for new real estate investors to learn. And, like any investment strategy, leverage has its benefits and risks. Therefore, understanding how leverage works is key to making wise investment decisions.
This article explains what leverage in real estate is and how you can use it to your advantage. This knowledge can help maximize return on investment (ROI) and achieve your financial goals. So, whether you’re a seasoned investor or just getting started, read on to gain a deeper understanding of the power of leverage in real estate.
What Is Leverage in Real Estate?
Leverage is a real estate investing strategy using borrowed money to maximize investment returns. Using other people’s money (OPM) to buy property means you invest less of your own cash.
This approach can amplify gains and significantly boost returns. However, leveraging has risks like interest rate changes and market performance.
A mortgage is the most common example of leverage in real estate. Most investors don’t have the cash to buy a property outright, so they use debt to purchase a property with leverage. They use their own cash for the down payment, and the rest—the lender’s money—is leverage.
How Does Real Estate Leverage Work?
Leverage works by using real estate financing to purchase an investment property. A mortgage or hard money loan is the most common source of financing. However, a home equity line of credit (HELOC) or loan, an FHA loan, a jumbo loan, or a private loan are also ways to use leverage.
The investor can reduce the amount of personal cash or liquid assets they invest. Instead, they use other people’s money. Therefore, you can purchase real estate that would be otherwise unaffordable, or you could use property leverage to finance several real estate deals and spread your risk exposure.
Here’s a short guide to how property leverage works in real estate:
- Initial investment: The real estate investor uses their own money for the initial investment—typically a down payment of at least 20%. However, it could be more or less, depending on the loan terms.
- Property ownership: After securing a mortgage loan and closing the deal, the investor gains full ownership and control of the property. This is despite the fact they make a proportionally small initial investment.
- Loan repayment: The investor makes regular monthly mortgage payments. As the mortgage loan is paid down, the investor’s equity increases. Typically, rental income covers monthly payments, or the loan amount is paid off in full when the property is sold.
- Profit potential: A leveraged property has profit potential from appreciation, rental income, or when it is sold. However, market fluctuations, interest rate changes, and depreciation can impact the investment’s performance.
With a relatively small initial investment, leveraged deals through loan financing offer the potential for greater returns on investment.
Example of buying a property with leverage
To see how standard leverage in real estate can work, let’s look at two examples: an all-cash purchase, compared to a down payment of 25%. Let’s assume that rental income and property values increase by 8% annually and expenses increase by 5%.
The investor makes an all-cash purchase on a property costing $120,000. At the end of five years, the property’s value has increased to $163,259, and the cash-on-cash return is 12%. Therefore, the property would yield a 36% return on investment.
Our other investor makes a 25% down payment of $30,000 on a property valued at $120,000. At the end of five years, the property has also increased in value to $163,259. However, comparing the cash-on-cash return, this investor has a return of almost 30%—2.5 times greater than the all-cash investor. The equity gain is greater because the investor made a lower initial investment.
Positive vs. Negative Leverage
Although leveraging can amplify returns on investment, it’s vital to consider the potential risks of leverage. Ideally, the investment returns exceed the cost of borrowing, resulting in positive leverage. However, negative leverage can occur when borrowing costs exceed returns.
Positive leverage in real estate
Positive leverage occurs when the investment property yields a higher return than the mortgage costs. Therefore, the rental income, cash flow, and appreciation result in profits compared to the initial investment. Positive leveraging also results in amplified returns compared to a nonleveraged property.
Negative leverage in real estate
Negative leverage occurs when the cost of borrowing exceeds returns from the property’s negative cash flow. You have an underwater mortgage when the mortgage balance exceeds the property value, which impacts your returns. Unfortunately, it can also land you in financial hot water if you cannot make mortgage payments.
Reasons why leverage in real estate can turn negative include:
- Buying investment property in a too-hot market
- A sharp increase in interest rates
- A downturn in the rental market
- Property values plummet
Types of Leverage in Real Estate
The three primary types of real estate leveraging are financial, operational, and market leverage. Most investors use typical leverage strategies like loans, mortgages, or tapping into home equity.
However, leverage also includes increasing rental rates, more efficient property management, and cost control. These tactics leverage the investment because they increase or maximize returns.
Financial leverage
Financial leverage is another name for taking out a loan to buy an investment property. Depending on your circumstances, several options exist to leverage real estate. Here are a few:
- Conventional mortgages: Traditional lenders typically let you borrow up to 80% of the property value. The monthly loan payments depend on the following factors:
- Loan amount
- Credit score
- Loan terms
- Down payment
- Type of property
- Home equity loans (HELOCs): You can leverage real estate by borrowing against equity in your home. For example, if you have enough equity, you can get a home equity line of credit (HELOC) or equity loan for the down payment. You can also benefit from lower interest rates.
- Seller financing: Another way to leverage real estate is by getting the seller to finance the deal. In these cases, you may be able to buy a property with little money down—or no money at all. Typically, with seller financing, you pay the seller monthly installments rather than a traditional real estate mortgage.
- Hard money loans: Sometimes, hard money loan financing is the best way to leverage real estate. Also called a bridge loan, this uses the property as collateral, and there is room for negotiation of the loan terms.
- Portfolio loans: You can combine all rental property mortgages into a single rental portfolio loan. This investment strategy can offer possibilities to get better deals and quickly scale your rental portfolio. Portfolio lenders are also more flexible than traditional lenders.
- Business credit cards: Using business credit can help make a down payment or pay for capital improvements. This allows you to improve your investment real estate portfolio without dipping into your own cash.
Operational leverage
Operational leverage in real estate refers to strategies to increase a property’s profitability. The goal is to maximize income and minimize costs.
Here are a few ways to leverage rental real estate:
- Increase rent prices to improve cash flow
- Reduce operating expenses like maintenance and property management
- Minimize vacancies
- Invest in capital improvements to add value and increase income potential
Market leverage
Savvy investors know how to use market conditions to leverage real estate. These strategies can involve selling when demand is high, investing in locations with growth potential, and taking advantage of low interest rates. Therefore, due diligence before buying an investment property is vital to maximize returns.
Importance of Leverage in Real Estate (Benefits)
The benefits of leverage come from using a small initial investment to buy profitable properties. Leveraging lets you use someone else’s money to buy, own, and manage real estate. Also, you can buy more expensive investment properties using leveraged investment opportunities.
Here are four principal benefits of real estate leverage.
Increased potential returns
The greatest benefit of leverage in real estate is amplified returns. Using real estate financing increases profit potential, and in many cases, you can buy significantly larger properties than unleveraged ones. Also, you make greater equity gains when the property appreciates.
Diversification
Real estate leverage enables you to diversify your investment portfolio. With borrowed funds, you can invest in multiple properties. This investment strategy spreads risk across different assets. So if one performs poorly, others may still generate returns. Diversifying reduces the impact of a single investment’s underperformance on your entire portfolio.
Tax advantages
Buying investment properties with leverage offers several tax breaks. Here are a few ways to reduce taxable income:
- Deduct mortgage payments.
- Write off rental property improvement costs.
- Defer capital gains tax by reinvesting in a “like-kind” property.
- Write off property depreciation.
For example, suppose you made an all-cash property investment. In that case, you would have no mortgage payments to include in your yearly tax returns. Instead, you would pay more tax because monthly rental income appears higher.
Wealth building
Using leverage in real estate builds wealth. The strategy works because you control investment properties for a fraction of your capital. Your finances benefit from additional income, tax breaks, and property appreciation. Additionally, leveraged investment opportunities amplify gains. These factors allow you to grow wealth over time.
Risks of Leveraging Real Estate
Any investment strategy has risks. Therefore, understanding leverage risks in real estate is crucial to protect your monthly cash flow and hard assets.
Some of the vulnerabilities of loan financing include:
- Housing market downturns cause property values to sink.
- Interest rate hikes increase borrowing costs.
- Vacancies impact cash flow, meaning you may not cover mortgage payments.
- High debt levels impact liquid assets and negatively affect your credit rating.
Due diligence can help you avoid the risks associated with leveraging real estate. Therefore, conducting thorough market research is crucial when considering loan financing for real estate investing.
Tips for Leveraging Real Estate Effectively (Safely)
When used wisely, leveraging is a powerful tool to invest less cash for higher returns. So what are some of the best ways to maximize the potential returns of every cent invested?
Here are some top tips to ensure you get the best out of leveraged deals. By following these tips, you can leverage real estate effectively while minimizing potential risks.
Set realistic goals
- Set realistic financial goals to avoid borrowing too much or overleveraging.
- Use conservative estimations for property appreciation, inflation, expenses, and mortgage payments.
Use risk management strategies
- Conduct extensive housing market research to find real estate investments with the best profit potential.
- Use BiggerPockets to educate yourself on the BRRRR method to build passive income quickly.
- Have an exit strategy for selling or refinancing if the real estate market slows.
- Maintain a reasonable loan-to-value (LTV) ratio to avoid excessive debt.
- Keep your personal assets separate from your business dealings.
Build a strong financial foundation
- Base profit forecasts on current market trends, not how markets have historically performed.
- Maintain a contingency fund to pay for unexpected repairs or long vacancies.
Diversify your investment portfolio
- Diversify your investment portfolio to spread the risk around.
- Consider investing in different regions or cities.
- Use a mix of investment strategies like fix-and-flip, rental, and buy-and-hold properties.
How to Calculate Leverage Ratios
Calculating leverage is crucial for determining the best way to finance real estate investments. Accurate calculations help to identify suitable properties. They also help determine if you can afford mortgage payments and running costs.
Let’s look briefly at three leverage ratio calculations to assist you in making the best investment decisions.
Loan-to-value ratio (LTV)
The loan-to-value ratio compares the real estate price with the loan amount. Calculating the LTV ratio is crucial for determining the size of the down payment. Higher LTVs usually mean higher-risk real estate loans and higher interest rates. Therefore, the mortgage may be more expensive.
To calculate the loan-to-value ratio, divide the loan amount by the appraised property value. The ratio is expressed as a percentage. Here is the calculation:
LTV ratio = ([mortgage amount] ÷ [loan amount]) x 100
For example, buying a property valued at $200,000 with a down payment of $40,000 is an LTV ratio of 80%. Here’s how it’s calculated:
($160,000 ÷ $200,000) x 100 = 80%
This means your initial investment is 20% of the total purchase price. Therefore, your equity is 20%, and you use 80% leverage for the investment.
Calculating LTV ratios is useful for fix-and-flip, rental properties, and buy-and-hold. A typical LTV ratio for real estate investing is between 70% and 80%.
Debt service coverage ratio (DSCR)
Calculating the debt service coverage ratio (DSCR) helps determine if a property is financially viable. This metric is based on the net operating income (NOI) and debt service.
For example, you would first deduct operating expenses from income to calculate the NOI. Then, you divide annual debt service—principal repayment plus borrowing costs.
Here is how to calculate the debt service coverage ratio:
DSCR = [net operating income] ÷ [debt service]
For example, suppose a rental property has an NOI potential of $19,200, and the mortgage principal and interest payments are $14,000 annually. In that case, the DSCR is 1.37.
$19,200 ÷ $14,000 = 1.37
The optimal ratio for debt service coverage calculations is anything over 1.25.
Equity multiple
The equity multiplier helps determine your potential return on investment compared to your initial investment. It can be useful to track current investments or calculate the projected ROI. The equity multiple calculations can help identify potential profitable real estate investments.
The calculation is based on all profits from the investment (total cash distributions). These include rental income and profit from the sale. You then divide the investment profits by the total equity invested. The result is the amount your equity has multiplied during the holding period.
Here is the formula to calculate equity multiple:
Equity multiple = total cash distributions ÷ amount invested
For example, suppose you bought a property five years ago for $200,000, and the down payment was $40,000. Let’s assume the property sells for $350,000, and the total interest payments were $50,000. Therefore, your profit on the property is around $100,000.
Let’s say during the holding period, you earned $95,000 in rental income. The equity multiple ratio is 4.87.
$195,000 ÷ $40,000 = 4.87
Therefore, for every $1 you invested, you received $4.87 in returns.
You can use an equity multiple calculator to compare similar properties in similar markets. However, it’s important to use the metric along with other metrics to calculate a potential real estate investment.
Final Thoughts
Understanding leverage in real estate is essential for any investor. It’s an effective tool to increase your buying power and amplify profits. It allows you to turn smaller initial investments into greater returns. Real estate financing can help diversify your portfolio, increase ROI, and give you several tax advantages.
However, like any powerful tool, you must use leveraging wisely. Therefore, understanding its associated risks is crucial to building wealth and enjoying positive cash flow and financial freedom.
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