Leverage is an important concept to understand and ultimately utilize for real estate investors. The idea of investing in real estate is to generate wealth, and the use of leverage is one of the key ways you do that.
Leverage means you borrow money to finance an investment. In real estate, getting a mortgage is the most common form of leverage. You’re borrowing from a bank or financial institution to buy a property.
How Does Leverage Work in Real Estate Investing?
In real estate investing, you buy properties with the goal of making a financial return. You have to use leverage in a way that’s going to allow you to maximize the return.
When you use leverage to your advantage, you can put little or no money down and take advantage of your debt to earn a return on your investments.
To put it all in simpler terms, leverage is the use of debt to increase your potential returns on other investments. While leverage is a valuable tool in real estate investing, it can also have downsides, particularly if the market declines.
Leverage lets you buy a property that costs more than the amount of money you have, or perhaps one that’s more than you’re willing to spend. You’re building wealth by using other people’s money, or at least that’s the hope.
Sometimes the easiest way to understand leverage is with an example.
Typically, when you’re going to buy real estate, it requires a 20% down payment. If you were going to buy a property that was $500,000, and you put 20% down, that’s $100,000. You borrow the rest, so you’re only using a small amount of your own money to buy the property. The rest of what you’re using is the money of your lender. Then, if there’s an appreciation on the property of 5% yearly, you’ve grown your net worth to $525,000 in this period of time.
If you had used cash to outright buy a property instead, then you would have spent your $100,000 that you used on a down payment.
You would see an increase of $5,000 for that property, based on the 5% appreciation rate. You would have just a $5,000 increase in your net worth versus the $25,000 if you went with the more expensive property.
What Are the Benefits of Using Leverage in Real Estate?
Some of the benefits of using leverage in real estate include a higher return on your investment, and you’re getting more for less. If you were to finance a rental property, for example, you would likely see a better cash return than if you bought with all cash.
You could also potentially buy multiple properties using leverage, so you’re going to see more cash flow, better tax advantages and perhaps more appreciation.
As far as taxes, when you leverage your real estate investments, you can depreciate your property’s total cost and not just the amount of money you put into it, meaning potentially significant deductions. You can also write-off the interest on your loan, so there’s another deduction on your taxes.
You’re building equity over time as you pay down your principal on your loan, and it’s equity that your tenants are actually paying for.
What Are the Risks of Using Leverage in Real Estate Investing?
As with anything in investing, there are risks of using leverage. Ultimately you are taking on the responsibility of loan payments no matter what. If you default on your loan, you can end up losing your whole investment.
You’re also vulnerable to not just the ups of the real estate market but also the downs. If property values fall, then you could have an investment that’s worth less than what you owe on it.
You also have to be careful with the terms of investment real estate loans because some can have high interest rates and other unfavorable features like short repayment timelines.
Sometimes the risks and potential downsides of using leverage can grow in scale when multiple properties are involved.
Overall, leverage can be a valuable tool for a real estate investor, but you have to be smart and strategic when tapping into the potential value. Before using leverage, you’ll have to have a strategy to keep yourself afloat to weather a bad economy or a lack of tenants.