Real Estate Leverage: An Overview
One of the best parts about investing in real estate is that you don’t need to have enough money to buy a property outright – you can get money from lenders to help with your purchase.
Taking out a loan to buy an investment property is called leveraging real estate, and it’s one of the top strategies to know about if you’re thinking about buying investment properties.
Keep reading to learn more about the use of leverage in real estate – and whether it’s a good idea or something to avoid.
What is leverage in real estate investing?
Leveraging in real estate is simply buying a property with other people’s money.
In short, you go to a lender, borrow money, and use the funds to buy an investment property – even if you have enough of your own money sitting around to make the purchase outright without a loan.
Why would you take out a loan if you don’t need to?
One reason is that leveraging can actually help you make more money on your real estate investment property in the long run — if the math works out. More on that later.
How to obtain funding for investment properties
If you’re considering financial leverage to fund the purchase of an investment property, here’s how to get started.
1. Have a strong ‘why’ for buying real estate
First, think about why you want to buy real estate and take out leverage. Think about the property you’re looking at and the potential return on investment. Consider whether it’s something you really want to do or if someone else is pushing you to do it.
To succeed in real estate investing, you have to tackle the responsibility. It’s not something you can do with half effort. Even passive income still takes some work to set up. You might not turn a profit during your first year.
In fact, most investors won’t.
2. Make sure leverage is the best option
If you decide that real estate is a good decision, make sure you’re in a position to ask for funding from a lender.
Check your credit score, which will play a major part in determining the type of loan you can receive. If you need to improve your credit score, pay down debt like credit cards or other loans.
It’s also a good idea to assess your overall financial situation and make sure that taking on more debt is a good idea.
If you’ve maxed out a home equity line on an existing property and are heading toward foreclosure, for example, now’s not the time to look to expand your real estate footprint.
3. Decide where you want to obtain funding
Once you’re confident that using leverage is a good idea, decide where you want to obtain funding.
You can get funding for leverage from a traditional bank or a credit union, if you belong to one; a credit union might give you a preferred rate as a member.
It’s also possible to obtain funding from a hard money lender or a private money lender. So assess your options, and don’t be afraid to shop around and test the market. Whatever you do, don’t feel pressured to take any loans without looking into all your options.
4. Evaluate the cash-on-cash return
One of the most important things you can do when deciding whether to use leverage for a real estate investment is to assess the cash-on-cash return.
That number represents your total return on the potential investment based on your down payment and how much money you’d make after repaying the lender and covering expenses.
Start with your potential cash flow, which is the property’s projected net income minus what you’d be paying in loans and expenses.
Then divide your cash flow by your down payment to get your cash-on-cash return.
You can run the same calculation again assuming that you don’t take a loan, instead paying for the property outright and avoiding monthly loan payments. See how the cash-on-cash returns compare for using leverage vs not.
5. Decide whether to take the loan
Finally, weigh all your options and decide whether to take a loan or pass on the opportunity. Sometimes, the best real estate investment is the one you walk away from.
The pros and cons of using leverage
As with most investing decisions, there are some pros and cons that come along with using leverage. Here are some of the top advantages of using leverage when buying real estate.
Advantage: Gain more capital
Leverage gives investors more capital to work with so they can spread their money around and invest in more income-producing properties.
Advantage: Buy expensive properties
At the same time, using leverage can help investors buy properties that are more expensive than they can afford out of their own pocket.
In both cases, real estate investors use debt to stretch their money further and obtain higher returns.
For example, Sam may want to buy a commercial property that’s valued at $1 million. However, he only has $250,000 in liquid cash sitting around for a down payment. So, Sam may approach a lender to get financing for the balance of the property price.
In another example, Toni may have enough in the bank to cover a $1 million property but decide to use leverage anyway. This strategy can enable her to put several smaller down payments on properties instead of going all-in on one particular location – reducing risk while opening the door for multiple returns.
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Here are some of the main disadvantages of using leverage with real estate.
Disadvantage: Putting a lien on real estate
One of the biggest downsides to using leverage is that it puts a lien on the property. So, while you’ll technically own the property, the bank can still seize it if you default on your loans by missing a certain number of payments.
This tends to be a bitter risk when buying expensive commercial properties. By taking out leverage for a property, you could wind up with a mortgage payment that’s more than you could comfortably afford.
Disadvantage: Taking on more debt
Buying a property with leverage can add significant financial strain, which can be stressful even if you have the money to make payments.
Carrying two or more loans is not easy for any borrower. It requires careful budgeting and financial planning – especially when you need to pay hefty property taxes.
Disadvantage: Market volatility
Another downside to using leverage when buying real estate is market volatility. Real estate prices may fall, causing property values to fall with them.
Frequently, borrowers obtain expensive loans only to wind up with properties that are far less than the amount they take out.
Tips for using leverage
There are a few things you can do to reduce risk when taking out leverage. Here are some tips to keep in mind.
Vet properties carefully
Before you take out a loan on a property, it’s imperative to run a complete assessment on it. Make sure the property passes all inspections – including advanced tests for mold, radon, and asbestos.
You’ll also want to work with a real estate agent to gain a thorough understanding of the local area and surrounding property values.
Try your best to predict the trajectory of the property at the end of the loan term. Of course, your goal is to buy something you expect will appreciate in value over time.
Go for longer terms if possible
Commercial real estate properties typically only have five-year terms. This doesn’t leave much time to refinance your loan or resell the property.
If the property value falls at the end of the loan term, it could make for a difficult financial situation. Whenever possible, try to extend the terms of your loan to give you as much wiggle room as possible.
Have money in reserve
When using leverage, one of the best things you can do to protect yourself is having money sitting around in reserve. That way, you’ll have help in the event you run into unexpected repairs or you have trouble finding tenants.
For the best results, try to save at least six months’ to a year’s worth of payments before taking out leverage. Stash the money in a high-yield deposit account for quick access when it’s needed. You can never be too prepared financially when taking out loans.
At the end of the day, you always want to be able to pull money from a personal account during an emergency situation. This is critical for success in real estate investing.
Make sure you’re in a position to buy real estate
If you’re new to the real estate market, you should also make sure that you’re in a position to buy an investment property. This is a big risk, and you have to be prepared mentally and financially before adding a property to your portfolio. Otherwise, you could be in for a rude awakening when the bills start rolling in.
Take a look at your overall financial situation from top to bottom and see whether real estate fits into the equation.
New real estate investors may want to consider investing in real estate investment trusts (REITs) before diving in and buying direct properties. REITs are bought and sold like stocks and can offer great returns. There’s also no property maintenance involved for you! REITs can allow investors to learn the real estate market while still investing and taking advantage of potential upside with less risk.
Frequently Asked Questions
Is it a good idea to use leveraging for a rental property?
It all depends on the quality and location of the rental property. However, rental properties typically make great leveraging candidates because they offer a high quality of return. As long as you can keep the place filled with paying tenants and you get a reasonable interest rate, you should feel comfortable moving forward with this type of deal.
When using leverage for a rental property, you’ll have to pay off the loan before you can start profiting. Some people prefer not to wait that long – especially due to changing market conditions.
If you want to start profiting immediately, consider buying the rental property outright.
Can you claim tax credits when using leverage?
The IRS allows real estate investors to depreciate the total cost of the property when leveraging real estate funds. This is a great tax benefit for investors, who can enjoy breaks while still using low-interest funds from lenders.
Of course, it’s critical to work with a tax professional when buying real estate to avoid any potential complications and to claim the most credits possible. Going it alone is not advisable with real estate investing taxes.
Does leveraging increase your net worth?
Net worth is a calculation that measures what you own versus what you owe. So when buying real estate, taking on property and building equity or ownership can enhance your net worth. However, taking out a large loan increases your personal debt, potentially balancing out or negating ownership gains.
Net worth is a personal metric and has no direct impact on credit score or any financial decisions. It’s simply a way to benchmark your financial progress and set goals for yourself.
Does leverage require monthly payments?
When taking out real estate leverage, you’ll have to pay the lender back on a monthly basis. Generally speaking, the lower the interest rate and the longer the term, the easier it will be to pay back the lender.
If you want to avoid a monthly loan payment, pay all cash and don’t leverage real estate.
The Bottom Line
Leveraging property is one way to grow your investment portfolio. And with the way leverage works, you could potentially walk away with a property with a higher purchase price than you would otherwise be able to afford.
Just do your due diligence and make sure that leveraging is the right investment strategy for your needs. It’s also a good idea to work with a trusted real estate agent who can help you understand the ins and outs of the housing market.
For many people, real estate investing is a calling. By using leverage intelligently, you can build up a portfolio of properties and unlock passive rental income streams before you know it. At that point, you’re well on your way to a life of financial freedom.