Have you ever wondered what leverage is or how it affects your returns in real estate investing?
When used properly, leverage can be a powerful tool to amplify your returns on your real estate investments. However, leveraging your real estate involves some risks.
Let’s take a look at some examples of how leverage can increase your returns and how to minimize your risks.
But first, let’s dive into the basics of leverage.
What is Leverage in Real Estate Investing?
Put simply, leverage is using debt to potentially increase the return on your real estate investment.
If you already own a rental property, you are probably using leverage (even if you don’t know it). Almost all rental properties are purchased, in part, with a loan or mortgage from a bank. This is the debt. You own a smaller portion of the investment and the bank owns the rest.
Using leverage, you can purchase a larger investment property with less money out of your pocket.
Advantages of Leveraging Real Estate Investments
Now that we understand how leverage works, let’s look at how it can benefit you.
The primary benefit to leverage is access to larger investments. You don’t need to cover the full purchase price of a rental property. You typically need only 20% of the purchase price. If you have $100,000 to invest, you can purchase $500,000 of real estate investments.
Also, you gain the full benefit of the returns — even from the bank’s share.
Let’s say you bought a $250,000 rental property in cash. While you owned the property, it has appreciated to $300,000. You gain $50,000. That’s a 20% return on your original $250,000 investment.
If you instead used leverage to finance the property, you have a $50,000 down payment with a $200,000 loan. The property still gains $50,000 of value. But in this case, you have a 100% return on your original $50,000 investment.
That’s a big difference, but let’s take this example even further.
If you had $250,000 to invest, you could purchase 5 properties worth $250,000 each. Assuming they all increase in value by $50,000. You now gain $250,000 (still a 100% return).
Compare this to the first example where you purchased the property outright with no loan. You invested the same $250,000 in both cases but used leverage to your advantage to purchase 5 properties. You have $200,000. That’s 5x more using leverage.
Risks With Leverage
Leverage isn’t all sunshine and rainbows. There are risks involved.
You can use leverage inefficiently and potentially dangerously; either over or under-leveraging your real estate investments. Both pose risks to your investment returns, but over-leveraging your real estate investments can cause you to lose your investments.
What is Over Leveraged?
Over-leveraging a real estate investment means taking on a debt load that compromises your ability to generate positive cash flow.
While leverage can help increase the returns on your real estate investments, you need to consider the costs associated with a loan. The income from your rental properties must exceed the expenses if you are using leverage properly. Otherwise, you are paying out of your pocket every month just to keep your rental property.
This situation isn’t scalable. You can’t successfully purchase and manage multiple rental properties if each one is costing you money.
Do you work for your investments, or do they work for you?
In the worst case, you will need to cover unexpected expenses from repairs or vacancies. What happens if multiple of your rental properties have these expenses? Do you have the cash to cover them? Or will you be forced to sell or face foreclosure?
Creating a positive cash flow even in the face of unexpected expenses will ensure you get to keep your rental properties. In other words, you can protect your real estate investments by ensuring a margin of safety in your cash flow calculation.
What is Under Leveraged?
Under-leveraging is using debt inefficiently at the expense of investment returns. It is the opposite of over-leveraging but does not pose the same risk of losing your investments.
The primary risk to under-leveraging is sacrificing future returns. As we have seen in the leverage example, using leverage can amplify your returns. Not using enough leverage prevents you from obtaining those gains.
How to Use Leverage in Real Estate
Over time, the amount of leverage you have in a rental property changes. As you pay down the debt and as the property appreciates, you have less leverage. You have a lower percentage of loan to the value of the property.
So how can you take advantage of this situation?
You can do a cash-out refinance on your rental property. This will give you a new loan for a higher amount and also give you cash in hand. It is important to consider your cash flow when doing this so you don’t end up over-leveraging your rental property.
Once you have this new infusion of capital, you can purchase another rental property to add to your portfolio. If you have a single property and purchase another, you have a good chance of doubling your investment gains as the local property market increases in value.
How Much Leverage Should I Use in Real Estate Investing?
There isn’t a magic percentage of leverage that applies to every rental property. Instead, the amount of leverage you should use on your rental property depends entirely on the cash flow.
When evaluating the right amount of leverage, you need to ensure positive cash flow. Remember, cash flow is king.
You also need to account for the unexpected in your cash flow estimations. What if your vacancy rate increases? Does the property need major repairs or improvements in the near future? What if the local rental market declines?
All of these questions need to be accounted for when modeling your cash flow and determining the appropriate level of leverage.
Conclusion
Leverage is an amazing tool to grow your real estate investment portfolio.
With a good understanding of both your cash flow and potential unexpected expenses, leverage can be used with a reasonable level of safety. Determining the appropriate level of leverage is a relatively simple mathematical exercise.
Do you use leverage to increase your real estate investment portfolio?