Leverage is the act of taking on debt to increase potential returns. Leverage in real estate can be advantageous when done correctly, but it can also cause great harm if not used properly.
Leverage works best when you can acquire a loan at a low-interest rate and then reinvest that money into an asset that will generate greater returns than your borrowing costs.
What is Leverage in Real Estate Investing?
Leverage in real estate is a bit different than with other assets. Leveraging means that you borrow money to acquire income-producing property to make money from it. Leverage investment in real estate can take many forms, but they each follow the same basic formula.
Leverage is most often done with real estate mortgages, but it can also be done through financing.
The most common real estate investment leveraging strategy is to put down a small amount of your own money and use the bank’s money for the rest. This allows you to buy more property than you would otherwise be able to afford.
The most significant benefit of this leveraging method is that your return on investment (ROI) will be more significant since you are investing with borrowed money.
When you acquire a real estate investment property with leverage, the bank will want you to make monthly payments on the loan. This means that your cash flow will be reduced by the interest you are paying for borrowing the money.
Therefore, when acquiring a property with leverage, it is crucial to find one that can generate income higher than your costs, including debt service.
How to obtain leverage in real estate?
To leverage a real estate investment, you first have to find an investor willing to loan you the money.
Most lenders require at least a 20%-30% down payment on the value of the property they finance, which leaves 80% of the property to be financed with a loan. When you take out a mortgage to buy a commercial property, the property you are buying most likely becomes the collateral for that loan.
The monthly payment amount is determined by two main factors: the interest rate and the term of your loan. The mortgage costs and interest rate may be fixed or variable and usually depend on the type and the property value.
As your principal repayment is deducted from the total amount of cash you owe for this loan, it shrinks significantly over time, allowing you to receive more cashback after every monthly payment.
Hard Money Loans
A hard money loan is an alternative form of real estate leverage. Even though it has more flexible lending requirements, it carries higher interest rates and costs than other loan payments.
Real estate developers and experienced investors often employ hard Money leverage. They use their funds to obtain non-recourse loans secured by income-producing properties, in turn using the property’s net cash flow for debt service.
Many real estate investors have found that hard money loans are the best way to capitalize on good real estate deals quickly. Hard money lenders can provide bridge financing for fix and flip, bridge, or buy/hold properties quickly. This type of short-term funding is ideal for investors who have a steady supply of potential investments but cannot take on too much risk at one time.
A Rehabilitation Loan is a short-term, flexible loan made to finance part or all rehabilitation costs.
The term could vary depending on the project type and expected timeline for completion, with loans typically being paid back over an average period of three months to twelve months.
Interest rates are generally fixed during this time frame but may have a variable rate option.
Equity loans are a form of real estate leverage that can be used for any project type and timeline, with a fixed interest rate and a more flexible repayment term than other types of real estate financing. They do not have a maximum loan amount, but the lender will often set one depending on your earnings and the value of the equity in your property.
Equity financing occurs when you bring in an investor to become part-owner of the property to share the profits. This arrangement also helps you avoid selling your equity in the property, which can be costly.
Recourse vs. Non-Recourse Loans
Recourse loans are a type of real estate leverage where the borrower is held personally liable for any debt beyond what has been paid in equity on the property. This is called recourse because the lender can seek repayment from you using any assets or income available to you.
On the other hand, non-recourse loans are secured by the property itself, and your credit obligation is limited to real estate.
How does Leverage in Real Estate Build Wealth for Investors?
Real estate loans are used to leverage your cash position in an investment. You can maximize leverage with a high loan-to-value loan, reducing your financial exposure. This can mitigate your risk and enable you to diversify your real estate portfolio. Let’s explore the main benefits of leveraging investment properties.
Higher Returns on Your Property Investment
When you buy $50,000 worth of stocks in the stock market, you will enjoy a return based on that $50,000 investment. On the other hand, if you use your $50,000 as a down payment with a 75 percent loan-to-value real estate loan, you can buy a $200,000 investment property.
In addition, you can also deduct taxes, interest, depreciation, mortgage payment, and other expenses on a real estate investment, which is not possible with other types of investments. Real estate and business loans can be used strategically to mitigate risk while maximizing your return on one property or multiple properties.
Scaling Up Your Real Estate Investment Portfolio
Most real estate investors choose to use their cash or obtain financing from private lending institutions that require personal guarantees. Using another form of leverage allows you to invest in more properties. You’re able to use the same amount of capital without moving beyond your financial limitations.
Raising thousands or millions of dollars through hard money lenders and equity investments is possible. Real estate investors can purchase different rental properties for more cash flow, tax benefits, and appreciation.
Avoidance of Accumulated Debt
Accumulating debt is a tool that allows you to buy more real estate properties with the same amount of money as before. However, this is usually a double-edged sword because it can limit your future growth. You want to avoid having too much debt or not supporting your current debt load due to the real estate market.
Using various forms of real estate leverage can allow you to create more cash flow so that you can pay off debts faster and invest in additional properties without accumulating excessive debt.
Tips for Using Leverage in Real Estate to Your Advantage
Investing in real estate is a long-term process that requires patience and knowledge. If you want to succeed as a real estate investor, it’s essential to focus on finding good deals and maintaining your potential investments pipeline. Here are some tips for using leverage:
Using borrowed capital or borrowing against other assets will help you invest more quickly and efficiently. However, it’s essential to be strategic when choosing the right financing. The goal is to have your investment returns be higher than your payment plus interest.
It is common for real estate investors to purchase different commercial rental properties, generating more rental income to pay off debts and earn a positive cash flow.
Have Enough Monthly Cash Flow
Ensure that you have enough monthly cash flow for day-to-day operations and continue servicing debt during an economic downturn or a real estate market correction. You also need to have enough capital to cover vacancies, maintenance costs, and unexpected expenses.
Be strategic about the timing of your investments. You want to be able to sell properties quickly without losing too much money if the market declines suddenly. This will help you avoid being stuck with a property that is difficult to manage or that has a low return on investment.
Be Mindful of Leverage Limits
While adding more debt can boost your returns, you also need to ensure that you can service the additional debt and maintain liquidity for your business. This is especially important if the market suddenly changes for the worst. During a crash in the market, prices could make it difficult for you to refinance or sell your properties.
Use Different Sources of Leverage in Real Estate Investing
Many investors choose to use multiple sources of leverage on their properties because it allows them to diversify their business risk.
Do the research and learn how to use more than one type of financing. You can use equity, hard money loans, and private lending institutions simultaneously. By using a combination of loans, you’re able to maximize your real estate investments.
Determine a Reasonable Leverage Amount with an investment loan on tier 1 commercial property, such as a multifamily property. You’ll have a hard time finding a loan-to-value that’s higher than 75 to 80 percent. Most lenders provide loans with lower lending values on other tiers, such as office buildings, self-storage facilities, and more.
To determine a reasonable leverage amount, a savvy investor will analyze their risk tolerance level, financial situation, and market conditions. You are aggressive with your leverage if your financing is on the higher end of the loan-to-value spectrum. You are conservative if your financing is on the lower end of the loan-to-value spectrum.
Tax Benefits of Real Estate Leverage
Real estate investors who obtain financing from banks or other lending institutions can improve their net income taxes. They can do this by deducting taxes, interest, mortgage payments, depreciation, and other expenses associated with the property. This is not possible with investments made in stocks or other assets that do not generate cash flow.
However, the tax benefits of borrowing are offset by risks because you are personally responsible for your debt rather than investing through a corporation that has limited liability.
Understanding the Dangers of Over-Leveraging Your Investment
Leverage is an effective tool for maximizing cash flow, reducing taxes on real estate investments and diversifying your portfolio. However, if you are not careful, the high degree of leverage can lead to damaging effects such as financial burden and foreclosure.
While you may be focused on keeping your up-front down payment amount as low as possible, keep in mind that there are situations when having more skin in the game is advantageous. For example, in the 2008 real estate crisis, property values plummeted sharply, and many investors who had high loan-to-value loans found themselves upside down with their financing. Even those at a breakeven point regarding the loan would have lost money through real estate commissions and other related fees if they sold.
Nobody wants to be forced to hang onto an investment longer than planned. When investing in real estate, one might encounter a scenario like this. You could avoid the potential for a significant loss on your investment by making a larger down payment.
In Summary, Should You Use Leverage in Real Estate?
Although the answer is different for everyone, you need to weigh your options and determine whether using leverage in real estate investments is a good choice for you.
For more information on leveraging real estate investments, please contact us at Point Acquisition to learn more about the benefits of using leverage to grow your investment portfolio and how we can help with your commercial real estate investments!