Real estate investing tends to carry these special opportunities that you could take advantage of to maximize your returns. Success in this industry actually revolves around taking calculated risks and making well-thought-out decisions.
Leverage has emerged as one of those intelligent decisions and strategic risks that you could use to accelerate your real estate wealth. Unfortunately, it remains one of those really misunderstood concepts in real estate financing.
Because it’s related to debt, some see it as a grim reaper. While others chose to see it as an angel that could bring you fortunes as an investor. Today, I’ll be delving into the core part of it and sharing all you will ever need to know about this idea, including the benefits of leverage in real estate.
What is Leverage in Real Estate?
Imagine walking into a bank, expressing your wish to purchase company stock worth $200,000, and then asking your financier to fund 85% of it and you’ll bring the remaining 15% to the table.
Your banker would probably cherish your courage. But they might laugh and kindly ask you to leave their office because that’s not how things work with that kind of investment.
But if it were a real estate investment, chances are they would agree or negotiate a deal with you. Now, leverage is when you use such a debt to multiply the potential return on your real estate investment.
Real estate investing is actually designed to exploit leverage for its benefit. A mortgage is a straightforward example of leverage in real estate. In Toronto, for instance, a 20% down payment combined with good credit history might get you to fully own the property you want. In this case, you’ll be using 80% leverage.
Another case of leverage is where you are in a partnership and your partners agree to finance a part of the cost required to obtain property. Or where the property seller is willing to fund a portion of the buying price.
What are the Benefits of Leverage in Real Estate?
Higher Cap Rate
Cap rate is what investors use to compare the profitability of a property. It evaluates the rate of return on the investment you make in a property.
Case 1: Let’s assume you had $150,000 and you invested all of it in a rental property. Right now, your rental income per month is $1,000 after deducting all the expenses. In a year, you are making $12,000.
If we divide that annual net income by your initial investment, the return you get is 8.0%.
Case 2: You had $150,000 but chose to go for leverage, with your initial investment being $30,000. Because you are making mortgage payments in addition to your expenses, your monthly net income is $420. Yearly, that would amount to $5,040.
Dividing that figure by the initial investment ($30,000) gives us a cap rate of 20%.
Now, which option sounds better? Your guess is as good as mine. With case two, you are getting more returns. Your cash flow may appear smaller, yet in essence, you are generating more money for every dollar that you have invested in the property.
Now, here’s the catch. Not every leverage property will deliver this kind of return. The rate will actually depend on your monthly expenses, initial investment, and cash flow. It’s possible to get a negative cash return. So, do some proper due diligence before investing in property. If possible, seek the help of an investment consultant.
You Get More For Less
In cases where you pour all your cash into one investment, that would be it. But in cases where you leverage, you still have the option to go for another property. Like in the example above, you can still get extra mortgages, meaning you get to own several properties.
Assuming they are all making decent returns, that would translate to more rental income and real estate wealth on your part.
Leveraging lowers your risk. Imagine using all your cash to acquire one property only for it to perform contrary to your expectations or to turn out as a bad investment. You will be left with nothing but losses to count.
But if you obtain several leveraged investment properties, you will still have an income to come back to if one or two of your properties turn out to be bad investments.
Picture a scenario where a tenant relocates and you are left to offset the expenses that follow. You’ll definitely be making negative cash returns, but with several properties on your portfolio, you could use the income from the rest of the investments to offset the expenses.
If taken advantage of in a proper way, leverage could turn you into a successful and happy investor. Here are some tips you will want to keep in mind as you figure out how to do this correctly:
- Don’t solely base your predictions for appreciation on history. The real estate market is known to be volatile.
- Higher payments tend to carry more risks. The promise of super great returns can lure you into going for a bigger mortgage, but should the market slow down or you find yourself dealing with non-paying tenants, your investment may turn into a nightmare.
- Do proper research about the property before investing in it. Evaluate its profitability and every other aspect that matters in selecting an investment property.
Leverage remains a highly debatable concept in the real estate world. You can clearly see the two sides of it. The truth is, if made use of in the right way, you will have a lot to enjoy as a real estate investor. But if you don’t go about it well, it could turn into your worst investment strategy. Take this opportunity to learn as much as you can about it before giving try. If you need more help figuring it out, we’ll be glad to help.