There is no doubt that investing in real estate is one of the most popular ways to diversify your portfolio. Real estate offers a variety of profitable investment options that can allow you to build wealth over time.
One common barrier to getting started investing is capital - it is necessary to have sufficient capital to make your initial investment. Unlike stock investing, you can’t just put down small amounts of money and expect to become a property owner.
So how do you get started when you don’t have hundreds of thousands of extra cash lying around? Luckily, real estate is an industry where you can utilize leverage. Leverage allows investors to put smaller amounts of money down and use debt to help realize returns. Read more to learn about leverage and how it can help you when investing in real estate.
What Is Leverage?
Leverage is the use of borrowed capital or debt to increase the potential return on investment. It can work to your advantage when the value of real estate rises, but it can also lead to losses if values decrease.
The most common way to leverage your investment in real estate is with your own money or through a mortgage. You can use the money of a bank or a private lender to supplement what you have in order to buy a home.
Using Leverage to Your Advantage
Example #1: Suppose you put 10% down on a house worth $300,000, a $30,000 down payment. If the house appreciates in value by $60,000 over the next 5 years and you sell, you’ll make a $30,000 profit on your original investment. So the house only went up in value by 20%, but the return on your investment was 100%.
Example #2: Let’s say that you have saved $50,000 to put towards a house and you have found two properties in the same area: a $250,000 house where you would need a mortgage and a $50,000 house that you could buy outright with cash.
If you choose the $250,000 house, the bank will give you a $200,000 mortgage if you put down the $50,000 you have saved. Let’s assume that real estate values in that area appreciate 5% over the next year, so in 12 months the investment is worth $262,500.
On the other hand, you could buy the $50,000 house outright. There would be no mortgage required and you would not be in any debt, but if property values went up 5% in a year, your investment would be worth just $52,500.
The greater increase in value in the first scenario demonstrates the potential net worth increase provided through the use of leverage. Imagine that 5% gain every year for 20 years. Over time, the use of leverage can have a very significant impact on your net worth.
The Risk of Using Leverage
Fortunately for real estate investors, property values generally tend to rise over time. However, if the market does take a downswing, leverage can work against you just as much as it can work in your favor. To demonstrate how let’s revisit our example from earlier: a $30,000 down payment on a $300,000 house.
Let’s say the house drops in value by $60,000 and you sell. If that happens, you won’t get any of your $30,000 down payment back, and even worse, you’ll have to pay $30,000 to the bank to pay off what’s remaining on the mortgage. In this case, the property has declined in value by just 20%, but your mortgage is underwater by 100%. You have lost more money than you initially invested.
Remember that leverage in real estate is most effective when home values are on the rise. To avoid losses, it is important to perform due diligence about the market you’re investing in. How have property values trended in the area? What factors, such as the development of amenities or the arrival of a major employer, will influence the economy in years to come? The answers to these types of questions are crucial to assure conditions are optimal for taking advantage of leverage.
Focus on Cash Flow
A major factor in building a successful real estate portfolio using leverage is to invest in a property that has positive cash flow. You should aim to have the income generated from renting out the property to cover the expenses, which include the mortgage, taxes, insurance, and maintenance. That way your property will be producing positive cash flow whether the value of your home is up or down, so hopefully, you’ll never be forced to sell when the market is down.
If your rental income, minus your mortgage expenses, is producing a nice monthly cash return, a year where your property does not appreciate in value won’t put you in a hole financially.
When used properly, leverage is one of the best ways to increase your return on investment in real estate. It enables you to buy a property with a relatively small amount of money down and allows the market to work to your advantage. Holding onto your leveraged property for a long period of time may not only generate profitable returns but monthly cash flow as well.