Using leverage in real estate investing provides a path for growing your wealth beyond what would be possible using only your own capital. Leverage makes it easier to build a portfolio and increase potential returns.
This article will give you a complete overview of how to use leverage in real estate investing. We’ll explain:
- What leverage means in real estate,
- The different tools you can use to access leverage,
- Strategies for making the most of your leverage,
- And the benefits and potential risks of leverage in real estate.
By the end of the article, you’ll be ready to find leverage of your own for your next real estate investment.
What Is Leverage in Real Estate? Leverage Defined
Leverage in real estate is when you use the resources of others to increase the returns on your investments.
For example, when you take on a mortgage to buy a home, you are leveraging debt from the bank to purchase a property that you might not otherwise be able to afford. You get to benefit from the property’s appreciation over time plus tax benefits. And, if you’re house hacking, you could also benefit from recurring income on your home. Yes, you have to repay the loan, but that mortgage allowed you to tap into financial benefits that could well exceed the cost of the loan.
In most cases, the resource you leverage is financial; you can use either capital or debt in a strategy aptly called “other people’s money” (OPM). But you can also leverage non-monetary resources like technology or insights from investors with more experience. We’ll explore the different types of leverage in greater detail shortly.
How Is Financial Leverage Calculated?
Real estate investment leverage can be calculated in a few different ways, depending on what information you’re trying to uncover.
For example, if you’re looking to see how much of an asset is leveraged, you can use the Loan-to-Value Ratio. And, if you’re looking to see the returns you’re getting based on the leverage of an asset, you can use the cash-on-cash returns calculation. Let’s take a closer look at each of these calculations.
To calculate the loan-to-value (LTV) ratio, simply divide the loan balance on a property by the property's current value.
Let’s say you have a $100,000 mortgage balance on an investment property that’s currently worth $675,000. By dividing $100,000 by $675,000, we find that 14.8% of the property is leveraged. And you own the other 85.2% of the value, which is your equity in the property.
Cash-on-cash returns (CoC) are one of the most important metrics for real estate investing. This calculation measures the profitability of a real estate investment in terms of how much cash is generated compared to how much cash is invested over a specific period.
CoC is calculated by dividing pre-tax cash flow for the period by cash invested during the period.
Let’s say you buy a large plot of vacant land for $1 million at the beginning of the year. You put $200,000 cash down as a 20% down payment (using debt leverage in the form of a mortgage to cover the remaining $800,000). You also pay $10,000 in closing costs out-of-pocket. At the end of the year, you sell the land for $1.1 million. At this point, you have made $58,000 in loan payments, reducing the principal loan balance by $10,000.
In this case, your total cash invested is $268,000 ($200,000 down payment + $10,000 closing costs + $58,000 mortgage payments). You have generated an income of $310,000 from the sale of the property (the $1,100,000 sales price minus the $790,000 remaining loan balance). So, your CoC is 15.6% ($310,000 - $268,000) ÷ $268,000).
CoC Calculation with Increased Debt Leverage
Now, to show you the power of leverage in real estate investing, let’s change one factor. Instead of putting down 20% and leveraging 80% in debt, let’s see what happens when you put down 10% and increase your debt leverage to 90%.
In this case, your mortgage payments for the year would increase to $65,000 (because of the larger loan), and your loan balance at the end of the year would be $889,000.
So, your total cash invested would be $175,000 ($100,000 down payment + $10,000 closing costs + $65,000 mortgage payments). You have generated an income of $211,000 from the sale of the property (the $1,100,000 sales price minus the $889,000 remaining loan balance). So, your CoC is 20.6% ($211,000 - $175,000) ÷ $175,000).
As you can see, leveraging more debt increased your cash-on-cash returns.
What Is Considered Positive and Negative Leverage?
Positive leverage is when using leverage increases your cash-on-cash return, compared to if you had paid all-cash for a deal.
In the example above, if you had paid all cash, your CoC would have been 10% ($1,000,010 invested compared to $1,100,000 income generated). This all-cash CoC is less than the leveraged CoC, giving you positive leverage.
Negative leverage is when your CoC is less than if you were to have purchased the project without leveraging debt.
This can happen when cash flows are weak and/or the cost of debt is exceptionally high. For example, at one point in the 1980s, interest rates were over 15%. These excessively high rates made it more expensive to borrow money and resulted in lower cash-on-cash returns for many of those who leveraged debt rather than paying cash.
Different Forms of Leverage in Real Estate
There are several different ways to use leverage in real estate investing. Consider the following options:
- Traditional mortgages. The most common means of leverage in real estate, mortgages are widely available and can offer a range of terms to suit your needs.
- Home equity loans. Home equity loans allow you to borrow against the equity you have in a property. You may use these funds to renovate the property, make a down payment on a new property, or simply retrieve your original capital investment.
- Home equity lines of credit (HELOCs). Similar to home equity loans, HELOCs allow you to borrow against the equity in your property. Unlike home equity loans, HELOCs are a revolving credit line, which means you can borrow against your credit limit as needed (rather than taking a single lump sum).
- Seller financing. In some cases, you might get a lower interest rate from the property’s seller than you can get from a lender. In seller financing, the seller lends you the money for the purchase, and you repay them in installments.
- Construction loans. Construction loans can give you the cash needed to flip a home or develop a multi-family property from the ground up.
- Hard money loans. If you are unable to secure a traditional loan, you might consider a hard money loan from a private lender. Just know that the interest rate is likely to be higher than with a traditional lender, which can cut into your cash-on-cash returns.
- Private equity projects. Rather than using debt leverage from a lender, you can use capital leverage from other investors. Private equity is when multiple investors pool their funds to jointly own and manage a real estate project.
How to Benefit When Strategically Using Leverage
Here are a few expert tips on how to optimize leverage in real estate.
1. Shop for Lower Interest Rates
The impact of interest rates on real estate investing can’t be overstated. The lower the interest rate, the lower the cost of borrowing money. And, the lower the cost of borrowing money, the greater your return on investment (ROI) potential.
Different lenders can offer different interest rates on different loan types. So it’s worth investing the time in researching offers from multiple lenders under multiple loan options.
2. Think Outside the Financials
As we mentioned earlier, leverage in real estate doesn’t need to be monetary. You can also leverage resources like skills, knowledge, industry connections, and technology platforms.
Let’s say you decide to invest in rental properties for the high return potential. But you don’t have experience in leasing or resident retention. In this case, you might decide to leverage the expertise of a professional property manager. The property manager can find qualified renters and handle lease renewal negotiations for you, perhaps educating you along the way. Their experience could result in lower tenant turnover, less vacancy loss, and higher ROIs.
3. Consider Crowdfunding and Syndication
Real estate syndication and crowdfunding have been growing in popularity in recent years, partly because they allow investors to leverage capital from other investors while also allowing investors to leverage the experience, connections, and systems of real estate sponsors who manage the project from start to finish.
Crowdfunding and syndication are very similar models that can be compared to the private equity projects we discussed earlier. In each case, investors pool their capital, whereby acquiring real estate projects that might otherwise require too much upfront funding to be accessible by individual investors. And because the projects are professionally managed by the sponsor, investors also take advantage of the sponsor’s extensive resources, which boost returns further.
The Potential Dangers of Leverage
While leverage is extremely useful for investors, particularly in low-risk markets like real estate, too much leverage can potentially increase risks beyond an acceptable level.
Here are some of the potential dangers of overleveraging your real estate portfolio:
- Market price declines could potentially result in negative equity. If you buy a property with 10% down and a sudden, dramatic market shift results in a 12% decline in property values, you could owe more on the property than the property is worth.
- Rental rate declines could potentially result in negative cash flows. Putting less money down on a property means that your monthly mortgage payments will be higher. This puts you at a greater risk of not being able to cover the monthly expenses with the monthly payments received. This negative monthly cash flow would mean paying the difference out of pocket. Worse, if you are unable to make the mortgage payments, the property could potentially be foreclosed on.
- Overleveraging too many properties could exacerbate negative equity/cash flows. You might be able to weather negative equity or negative cash flows temporarily on a single property. But what if you have several properties that are overleveraged when changing real estate market conditions cause negative equity/cash flows? If you are unable to absorb the losses, you could potentially lose multiple properties.
How to Avoid the Dangers of Leverage
You can mitigate the risks of overleverage by maintaining “reasonable” LTV ratios and diversifying your portfolio.
The lower your LTV ratios, the more equity you have in a property. This equity acts as insolation against detrimental market conditions. While there is no magic number to strive for, you can use your personal risk tolerance to find a balance you’re comfortable with. Some real estate investors aim to have at least 20-30% equity in their properties (which is loosely based on lender’s criteria that owners maintain this percentage when borrowing against their equity).
Then, by diversifying your portfolio, you can protect your investments from localized market dangers. For example, if all your holdings are in a single small town, and the big employer for that town closes, the value of all your properties could potentially decline. But, if you balance small-town properties with properties in some of the best cities to invest in real estate, your big-city gains could potentially offset your small-town losses.
Understanding the Bottom Line with Gatsby Investment
Gatsby Investment is a real estate investment company that specializes in real estate syndication. Every day, thousands of real estate investors like you leverage our resources to increase their return potential.
When you invest with us, your capital is pooled with capital from other real estate investors, as well as our own capital, allowing you to leverage other people’s money to access unique deals that would be difficult to find and fund on your own. You also get to leverage our experience, skills, and network of industry professionals, including analysts, architects, designers, and builders. Just as importantly, you get to leverage our innovative online investment platform, which makes it easy to find new opportunities, review financial projections, and track your investments from start to finish.
Learn more about Gatsby and leverage your next real estate investment today!