The Real Lowdown On Leverage

You have probably heard about real estate investors who use leverage to purchase an investment property. This technique involves putting up a small amount of your own capital relative to the price and using the bank or another source of financing for the rest. Some investors swear by this technique, but is using leverage for financing your investment really a good idea?

Leverage vs Loan-to-Value Ratio

The leverage on your investment is the total amount of debt on your property as it relates to the current value of the asset in the marketplace. Leverage differs from the Loan-to-Value ratio because it takes all debt into consideration, while the Loan-to-Value ratio only looks at a single loan such as a first mortgage. So while the Loan-to-Value ratio looks at your mortgage as a percent of the value of your property, leverage includes the primary mortgage loan plus any secondary mortgage or and/or other financing.

The Pros of Leveraging your Investment Property

You can use leverage as a way to increase the potential return on your real estate investment. The cost to finance your debt is generally less than the return that your property will generate. If you decide to invest $100K and leverage the property at 50 percent, you will be able to purchase a $200K building. If you invest your $100K and use 75 percent leverage, you can buy a $400K building.

Example:

Say that both the $200K and the $400K property appreciate by 10 percent in the first year. The first investment will increase by $20K in equity, while the second investment will increase by $40K, if things go as expected. In both cases, you put the same $100K of your own money into the investment, but your equity is double in the first year for the $400K property. Leveraging can also provide tax advantages for depreciation and increased cash flow for an greater Cash-on-Cash return.

The Cons of Leveraging your Investment Property

Many investors use leverage to some degree, but as some investors found out during the last recession too much leverage can present a too much of a risk. If things do not work out the way you planned and you put $20K of your own money into a $100K investment property with the bank shouldering 80 percent, you are at risk for your $20K while the bank is at risk for $80K. If property values drop in value and you find that you are “underwater,” you can lose your investment and wind up owing money to the bank.

Example: In a precipitous down market where the market value of your investment property drops 25 percent, your $100K property is suddenly worth only $75K. In that case, if you were to sell you would lose 100 percent of your $20K investment, and you would still owe the bank $5,000.

Tips for Mitigating Risk when Using Leverage

Putting leverage on your real estate investment properties can produce greater returns, but it is important not to overuse leverage and place yourself at too much risk. Experienced real estate investors mitigate their risk by setting aside funds to cover emergencies and by performing extensive due diligence to find properties with a strong potential. Before signing on the dotted line, make sure your investment opportunity is in a good location, has a low vacancy rate and is in reasonably good condition. Leverage is not for everyone, but if you buy smart and mitigate your risk you can do well.