Have you ever wondered how certain people are able to go from having relatively little money and zero investments to having a booming real estate investment portfolio in a matter of just a few years? In most cases, it comes down to the powerful concept of leverage. But as great as leverage is, it’s easy to become over-leveraged and destroy your finances. The key is to understand how to do it appropriately.
What is Leverage?
According to the Forbes Real Estate Council, “Leverage is generated by using borrowed capital as your funding source when you invest. This allows you to buy a much larger asset and increase the potential return on your investment than you could if you had to pay 100% of the purchase price upfront. As real estate experts like to say, leverage enables you to make money on other people’s money.”
That sounds pretty straightforward in principle, but what does it actually mean? In other words, how do you use the power of leverage to increase your returns and maximize your potential?
The best way to understand leverage in practice is to look at some examples. Consider three different scenarios in which you have $100,000 to put toward a real estate investment:
- Scenario 1: You pay $100,000 cash for a property. (Zero leverage)
- Scenario 2: You put $100,000 down on a $200,000 property, while securing a bank loan (mortgage) for the remaining $100,000. (50 percent leverage)
- Scenario 3: You put a total of $100,000 down on two $200,000 properties, using financing to cover the remaining $300,000. This leaves you with $50,000 in equity and a $150,000 mortgage note on each property. (75 percent leverage)
Now let’s say that property values increase by 7 percent in a year. If you were to look over the financials of each scenario after the property values appreciate, here’s what you would find:
- Scenario 1: The property is now worth $107,000. (Net gain of $7,000 on the cash invested.)
- Scenario 2: The property is now worth $214,000. (Net gain of $14,000 on the cash invested.)
- Scenario 3: The cumulative value of the two properties is $428,000. (Net gain of $28,000.)
The beauty of leverage – and bank financing – is that each of these deals can be initiated using the same $100,000 in cash. The returns range from 7 percent to 28 percent – dependent on the amount of leverage used.
Mistakes to Avoid When Using Leverage
In theory, using leverage in real estate investing sounds like a no-brainer. The problem is that the real world is far from perfect. If you aren’t careful, you can quickly become over-leveraged, which is a scary place to be. But you can typically prevent this danger by avoiding the following mistakes:
- Never count on high appreciation. While real estate is pretty much guaranteed to increase over long periods of time (think 10, 15, or 25 years), there’s no promise that it’ll increase over a one-, three-, or even five-year span. This is a hard concept for people to grasp in the midst of an unprecedented decade of appreciation. Even if a property has seen double-digit increases each year over the past five years, you should never count on that same fortunate growth next year (or any year beyond). Anticipating such returns can lead you to overpay for properties. Then, if the property doesn’t increase, you’ll find yourself in trouble. Even worse, a property that loses value could put you underwater.
- Avoid excessive payments. It’s easy to confuse the idea of what a bank will offer you and what you can actually afford. In other words, a bank may offer you the chance to buy a $500,000 property with just five percent down, but if the payments are too high for your monthly budget, can you truly afford the investment? High payments leave very little room for margin, should the market soften. If you can’t make your payments, you risk losing your investment and tarnishing your credit for years to come.
- Making bad investments. Don’t let the allure of leverage force you into a bad investment. Just because you can buy a property with less cash down, doesn’t mean you should. Sometimes it makes more sense to throw in extra equity (especially when it means getting a lower interest rate or avoiding fees like private mortgage insurance).
Leverage is tempting. Sometimes it makes sense and other times it exposes you to unnecessary levels of risk. It’s up to you to make the right decisions.
How to Use Leverage Wisely
Leverage is powerful, but it must be used strategically. You have to continually be on the lookout for the right conditions and ready to turn down deals that don’t meet your stringent requirements. This is why proper due diligence is so important.
The Forbes Real Estate Council encourages investors to ask questions like, “How have property values trended in the area? What known factors, like the arrival or departure of a major employer, will influence the economy in the months, years and decades ahead? What are the expectations for the broader regional and national economy for the foreseeable future? The answers to these and related questions are critical.”
Secondly, you need a clear and unwavering investing strategy. Whenever you’re considering buying a property, ask yourself whether it’s a short-term or long-term play. Based on this answer, you can develop a set of factors and rules regarding when you exist the investment and when you stay put. Thus, when the market starts to change, you don’t have to stop and think.
Thirdly, use common sense. If your gut tells you that you’re taking on too much risk with too little potential for reward, walk away. Real estate investing always comes with some inherent risk, but there needs to be a limit on how much you’ll accept.
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At Green Residential, we’re in the business of helping Houston-area homeowners, homebuyers, and real estate investors maximize their assets and make smarter decisions in how they buy, sell, and manage real estate. For more information on our services, please contact us today!