What is Leverage in Real Estate?
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Summary:
Leverage in real estate is when you use borrowed capital to increase the potential return of your investments. Leveraging includes purchasing properties typically outside of your price range or purchasing multiple properties when you would normally only be able to buy one. There are risks involved, so make sure you understand the leveraging process before you decide to take the plunge.
There’s no doubt that having a real estate business can make you a lot of money. However, gaining the capital for an investment property can take time. Savvy real estate investors can skip the wait by leveraging, or borrowing money to purchase a property. Below, we will go through some essential tips to keep in mind when leveraging real estate.
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What is leveraging for real estate investors?
Leverage is the use of borrowed money to increase your real estate investments’ value, or return. You pay a portion of the purchase price in real estate investing, just like purchasing a regular home. The difference in this form of investment is that it is specific to increasing potential returns.
Think of it this way: you are already a homeowner from the first day you buy your house. You enjoy all the perks of homeownership despite only having paid for a small portion. So when applying this logic to a broad scale, you can see the more significant earnings potential. For example, you can get a home equity loan or line of credit on one property and use it to purchase another property. Do this more than once and your returns could multiply.
Unlike traditional forms of investment properties, your only goal isn’t rental income. Instead, your goal is to increase your earnings potential through acquiring more property (either by value or number of properties). You can also take advantage of rising home prices in a desirable neighborhood through a quick resale.
How does leveraging real estate work?
Real estate leveraging follows the following steps:
- You buy the property (or properties) using borrowed capital with a down payment.
- The home value appreciates or depreciates by some dollar amount.
- In the meantime, you can earn money by renting out the property.
- You obtain low-interest loans secured by the property to purchase more property.
- You resell the appreciated home to make a profit
Who needs to use leverage?
Real estate investors who can afford an all-cash purchase don’t need borrowed money, but they still may choose to use leverage to grow their portfolios faster. Leveraging real estate typically falls into one of two needs:
- You want to invest in multiple properties at once
- You want to invest in higher-value investment properties out of your current range
When your investment increases in value, you can resell the home at a higher price. In real estate investing, this is known as property appreciation. A 5% appreciation rate is much better on a $500,000 property than a $50,000 property.
Using leverage to multiply the returns on appreciation
One of the best ways to use leverage in real estate is to borrow money to purchase a property and then use that property as security to buy another revenue-earning property. As you generate equity in the new property, you can do it again and again, buying more properties and building more cash flow.
An example of leverage in real estate
In this example, we have Scott, Bob, and Tom. All three of these individuals bought a house on the same street for $100,000 at the same time.
| $100,000 Purchase Price | Scott | Bob | Tom |
|---|---|---|---|
| Mortgage Amount | $0.00 | 50% | 75% |
| Debt | n/a | $0.00 | $0.00 |
| Initial Equity | $100,000 | $50,000 | $25,000 |
The only difference is that Scott paid 100% cash for the purchase price of the asset, Bob took out a 50% mortgage, and Tom took out a 75% mortgage. To keep things as simple as possible, we will assume that both Bob and Tom have a fixed interest-only mortgage at 4% with a 30-year term.
| $150,000 Property Price at Sale | Scott | Bob | Tom |
|---|---|---|---|
| Interest Payments Accrued | $0.00 | $10,000.00 | $15,000.00 |
| Mortgage Balance | n/a | $50,000.00 | $75,000.00 |
| Total Equity | $150,000.00 | $90,000.00 | $60,000.00 |
| Total Profit on Initial Equity | $50,000.00 | $40,000.00 | $35,000.00 |
| Total Return on Initial Equity | 50% | 80% | 140% |
Now the property sells five years later for $150,000. Scott, who paid all cash, made a 50% return on investment. However, the ROI is much higher for Bob and Tom, who used debt (even when applying the interest on the mortgage payment and considering a smaller down payment).
But the use of leverage doesn’t have to stop there. For example, Tom decides to leverage the property further by getting a $25,000 home equity loan on the first home and using the money to put a 25% down payment on another $100,000 property. After five years, he sells the second property for another $150,000.
| 2nd $100,000 Property | Tom |
|---|---|
| Uses home equity loan to pay for the down payment | $25,000 |
| Debt | $100,000 |
| Initial Equity | $0 |
| Interest Payments Accrued | $20,000 |
| Total Return on initial investment if Tom sells for $150K | 260% |
In this scenario, Tom would generate a 260% return on his initial $25,000 investment.
Pro Tip
The goal of leverage is to take advantage of 100% of the asset while only putting down a small down payment. However, you’ll want to shoot for a 20% down payment to reduce monthly costs over the loan term. When you pay a minimum of 20% for a down payment, you avoid private mortgage insurance. Also, lenders see you as less risky, which may help you qualify for lower interest rates.
Financing methods
Whether you are using leverage to purchase one property or multiple properties, you will need an investment property financing method. Check out your options below.
Use your own money
Using your cash is the easiest method of getting the money to leverage real estate. “Your cash” refers to the money you can acquire due to existing assets. In this case, you’ve got these options:
- A cash-out refinance. This refinancing method allows you to get a lump sum of cash right away by using the equity you have built up in your home.
- A home equity loan. This loan is one form of getting a second mortgage on your house. This method increases your mortgage payments.
- A home equity line of credit. A HELOC is similar to opening a credit card against your home. You don’t get a lump sum; you get approval for an amount you spend as much or as little as you want.
- Shared equity agreements. Sell a slice of the future equity in your home while maintaining 100% ownership of your home. When your home sells or when the contract term ends, the investors receive their shares from the sale.
- Business lines of credit. These credit lines offer way more flexibility and growing room than HELOCs. If you have an existing business, you can use its revenue and profits to increase your usable capital.
This access to funds is the direct result of proving your ability to handle investment property and long-term loans. If you cannot borrow against your home, you need to use other people’s money.
Use other people’s money
Naturally, you might be skeptical of borrowing other people’s money. However, if you want to finance an investment property, you have some great options:
- Hard money lenders.These lenders typically look for investors with experience in the real estate industry. However, hard money loans are ideal for people looking to leverage the property for quick resale. They have short terms and high interest rates.
- Private money lenders. If you know a wealthy investor who trusts your judgment, reach out to them. If you speak personally with someone, you’ll have to bring a business plan to convince them you are worth investing in.
- Real estate syndication platforms. Syndicates like Fundrise gather real estate investors into a pool and allow them to buy into private commercial and residential properties using an investment platform. The barrier to entry is as low as $10, so you can dip your toe into real estate investing without buying a whole property.
- Commercial real estate loans. Using commercial loans indicates you perform real estate investment as a business. This situation might be applicable if you already have a real estate investing company. If you have a successful business, you can get great interest rates.
There are some cases where you can use a standard bank mortgage loan. However, if you plan to purchase more investment properties, you’ll need to rely on alternative sources. A single mortgage loan doesn’t give you much flexibility to purchase multiple properties.
Pro Tip
Avoid private loans if you can. These loans typically have the highest interest rates, which can result in a negative cash flow. Stick with real estate loans where you can put up collateral. Your financial history can give you a great interest rate.
The benefits of using leverage for real estate investment
If you are still on the fence about leverage in real estate, consider some benefits that come with the practice:
You can invest in more properties
Having a diverse investment portfolio applies to both stocks and the housing market. Leveraged real estate investors have the advantage of working across multiple properties. This is your real estate portfolio in action.
If those properties are in various areas, you increase your odds of potential earnings and reduce your risk of loss. For example, finding out one of your properties was built over a landfill might hurt your chances of selling. But owning real estate in multiple spots can prevent all that money from going into the same dump.
You can invest in higher property values
The higher the price of the home, the more it can potentially appreciate. But investing in high-value properties can be challenging, especially when you are starting out in real estate. Leverage can help you seek higher-value targets.
However, you never want to put all of your money in one basket. There is such a thing as too much leverage in real estate. Balancing it out and using leverage to target clear winners can boost your earnings without taking too much risk.
Pro Tip
You need actionable data that proves real estate prices are going up in the area — using websites like Zillow helps. Or use the Federal Housing Finance Agency’s House Price Calculator to see how homes in your area have appreciated over different time periods.
It offers quicker returns than a rental property
Compared to other forms of real estate investing, leveraging your property can result in a quicker return. Instead of just making a few hundred dollars a month on rental income, you could feasibly sell the property after one year of ownership. The result is an immediate form of cash flow into your pocket. While you shouldn’t rely on a massive appreciation in property values, real estate tends to go up over time. And sometimes you get lucky and see a big jump.
The risks of using leverage as a real estate investor (and how to avoid them)
Of course, there are also risks to leverage in real estate. Below are some examples.
You can suffer from lower cash flow
Cash flow is king with any investment property. If you aren’t actively making money on it, you make it harder for yourself to pay for it. This can be doubly painful if your property values go down.
To avoid low cash-flow issues, you’ll want a diverse portfolio of real estate investments. While rental properties don’t give you that sweet immediate return, consistent money can help you survive. Keep this in mind when trying to make that mortgage payment while leveraging.
You might lose on property values
Property values can go down just as easily as they can go up. This is the natural risk of real estate investment. If you own multiple properties in a group, you might feel this pain even more.
Using our earlier example, let’s look at what happens if that $100,000 property declines 10% in five years and all three buyers need to sell. Tom, who used the most leverage, loses the most.
| $90,000 Proper Price at Sale | Scott | Bob | Tom |
|---|---|---|---|
| Interest Payments Accrued | $0.00 | $10,000 | $15,000 |
| Mortgage Balance | n/a | $50,000 | $75,000 |
| Total Equity | $90,000 | $30,000 | $0.00 |
| Total Return on Initial Equity | -10% | -40% | -100% |
To avoid this potential, you’ll want to follow the same advice as above: have a diverse portfolio of investments. Leveraging offers a natural solution by allowing you to invest in multiple properties. However, if you choose to leverage to try to buy high-value properties, you might have an overpriced property that’s difficult to resell.
Understanding the neighborhood, looking at the home, and knowing market trends are all crucial in a high-value purchase. Having a good interest rate won’t matter if you bought the wrong property.
Having a high mortgage payment
If you don’t do the math, you might miss something and cause your monthly payments to overcome your cash flow. Breaking everything down beforehand and overestimating your costs are often your best strategies. Calculate your monthly costs, including insurance, your mortgage (at different rates), taxes, and other fees. Overestimate what you’ll pay for your investment property and leave yourself room for adjustments.
How to calculate leverage with real estate investing
To ensure you will make a good return on your investment property, you’ll want to calculate two aspects of leverage: cash-on-cash return and loan-to-value ratios.
Cash-on-cash return
A cash-on-cash return compares your annual pre-tax cash flow on an investment property to the amount you invested or paid on the mortgage in a year. You can use it as a forecasting tool to determine whether your earnings will exceed your costs. Here’s the formula:
COC return = annual cash flow (income minus expenses) / cash invested
Leveraging can help you improve your cash-on-cash return. If you paid $100,000 cash for a house and your annual cash flow was $10,000, your COC return would be 10%. But if you put down 20% and took out a loan for $80,000, even if your cash flow went down to $5,000, your COC return would be $5,000/$20,000 or 25%.
Loan-to-value ratio
LTV, or loan-to-value, is a ratio that compares your loan balance to the property’s appraised value. Lenders typically use this ratio to determine your risk level and the type of loan you can get. But it can also be a quick way to determine whether you should continue to keep the property or sell it. Here’s the formula:
LTV = loan balance / appraised value of property
Unlike cash-on-cash return, this ratio is more of a long-term look. So if you plan on keeping the property for multiple years, you can run this to determine scenarios if the property appreciates or depreciates.
Using the two ratios above will give you a basic idea of whether you should buy and when to sell. Knowing the investment property value is a significant first step.
FAQs
What does 80% leverage mean?
Having 80% leverage means you’ve made a 20% down payment. The loan company provides the other 80% of the cost.
What is an example of leverage in real estate?
You want to purchase a property for $500,000 in a neighborhood where real estate prices are rising. You don’t have enough cash to cover the whole amount, so you make a 20% down payment and borrow the rest of the money. Now you have 80% leverage, or $400,000.
What are two types of leverage in real estate?
To purchase real estate, you can borrow money from yourself or you can borrow money from someone else. You can use your home equity to borrow from yourself. Or you can borrow from a lender via hard money loans, private loans, or commercial loans.
How can I leverage my home equity?
You can leverage your home equity through a line of credit, a second mortgage (home equity loan), or a cash-out refinance. A home equity line of credit, or HELOC, is an excellent starting point if you want to try it out.
Key takeaways
- Real estate leverage is when you use borrowed money to increase the potential return of your investment property.
- Leveraging property allows you to pay a portion of the overall cost to use the property for resale or rental throughout your ownership.
- Leveraging can yield incredible results if done correctly with consistent cash flow.
- You can borrow money from yourself, using your home equity or the revenue from your business. Or your can borrow money from someone else via hard money loans, private loans, investment platforms, or commercial loans.
- Leveraged real estate investing is best done in a location with consistently rising real estate values. Be sure to research home values and calculate potential returns.
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Cara Corey is a writer and editor who loves to help people make sense of confusing topics. Her work has been featured in many blogs, newspapers, and magazines, including the Des Moines Register, Boulder Daily Camera, Better Homes and Gardens, and Parents Magazine.
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