What is leverage in real estate?

Question

Hello, I am a new investor, Saturn Arch Properties, LLC. For the past 7-months I have been working on my business plan, reading books, and learning my market. I recently establish a method to quickly analyze property and now I am focusing my attention on financing my deals. I came across the word "leverage" very multiple times. I want to be sure that I understand what "leverage your property" or "property is highly leverage" means. So far I know the dictionary meaning is maximum advantage and/or use borrowed capital and expect profits greater than interest payable. Can someone enlighten me on leverage in this industry?

Yolanda Higgins · Answer

Yes, thank you.

Brent Coombs · Answer

@YOLANDA HIGGINS, I believe you generally have a good idea about leverage, but I would change the explanation somewhat. Firstly, "income, expenses and cash flow" are important!

[The problem with your $500k example is that your Loan Interest Rate is likely to be about the same as that "5%", which places even greater importance on its income/cash flow. I suggest that instead, try examples where the houses are the same value and same income, but leveraged differently].

Instead of "Leverage is the use of borrowed capital to increase the potential return of an investment", I would change that to: "Leverage is the use of borrowed capital to increase the potential return of your own money/deposit".

Many folk have the aim to be able to purchase deals with zero of their own money (left) in each deal, meaning 100% leverage! (eg. Look up "BRRRR strategy").

ie. If you've got deal after deal making money from 100% borrowed money, then your own money can be used to carry on buying even more deals (then, Refinancing them)!

Is that clearer? All the best...

Yolanda Higgins · Answer

I have been doing more research to better understand leverage. I read a few BP posts but finally call across a website that gave me conceptual understanding. If I can explain it, I know it.

Leverage is the use of borrowed capital to increase the potential return of an investment. This is important because as an investor, I can use less of my own money to purchase property that will generate higher return. It is vital to crush the numbers and thoroughly analyzing property. Cheaper does not always mean better. I was getting hung up with taking income, expenses and cash flow into consideration. Let’s take this scenario for example:

Let's say that you've been looking for a house in a great neighborhood. You find two properties: a $500,000 house for which you will need a mortgage, and a $100,000 house that you could buy outright.

Scenario 1: You move ahead with the $500,000 house, and the bank will give you a $400,000 mortgage if you put down $100,000, or 20%. Assuming that real estate in this area goes up perhaps 5% a year, in 12 months the investment is worth $525,000.

Scenario 2: You buy the $100,000 house outright there's no mortgage and you don't owe anybody anything. If the real estate market goes up 5% a year, in 12 months your investment is worth $105,000.

For leverage, Scenario 1 is the better option. If both property generated the same income, Scenario 2 would be a better option.

Yolanda Higgins · Answer

Thank you for everyone response. I greatly appreciate it.

Brent Coombs · Answer

@YOLANDA HIGGINS, another way of saying "leverage" is: "debt, as a proportion to market value".

eg. If you owe $180k on a home that's valued at $200k, that's highly leveraged!

(That could be good or bad, depending on what other assets you bought with some of that borrowed money over the years other than just that home, or, how soon will the home be worth lots more?)

As a general rule of thumb, if the only way of buying your primary is by highly leveraging it (eg. with an FHA-approved low 3.5% deposit mortgage), then that's not really starting your "business plan", unless you're paying way under actual market value in the first place, and/or it's also a multi-family building (up to a 4-plex), enabling extra income to be earned from it.

Conversely, if you only owe say $20k on that same $200k home, that's low leverage, which also can be good or bad, depending on what your financial goals are!

eg. To help your business plan along, you may well want to have a much higher leverage against your primary than just 10% (up to say 70%, = borrowing a further $120k) - to buy well sourced investment properties, without needing to save any more deposits. Welcome to BP...

Kevin Lefeuvre · Answer

You never actually hear property is highly "leverage" but "leveraged".

When you buy a $200k property by putting only 10% or $20k down, thanks to a 15 years mortgage which is paid off after 15 years,  even with no appreciation,  your  $20k equity has been raised (or leveraged ) to $200k. Almost automagically.

The more you get a loan, the less you put down the more you leverage.

Other than that like for everything else Google is your friend.

Karen Margrave · Answer

@YOLANDA HIGGINS Rather than answering your question, I wanted to show you that if when having such a question you take the time to do a search of BP, you will find there's probably other posts where it has been discussed.

In putting in the word leverage, the posts in the link below came up. I'm sure they will be informative. If after reading some of them, you don't understand leverage, please message me, and I will help explain.

BP is the best site in the world for finding information related to anything about real estate. Very rarely will someone find a subject that hasn't already been discussed. However; if you can't find information, or have specific situations you need help on, people are more than happy to help you.

You might also upload a photo to your profile, it gives your posts more seriousness and character. If for some reason you don't want to put your personal photo online, use a photo of a local landmark, or something that tells who you are.

Good luck. Here is that link on Leverage