What is Leverage in Real Estate and How to Use It Wisely?

Leverage in real estate is the use of borrowed capital or debt to buy properties that can generate more income than the cost of borrowing.

It is a technique to increase the potential return of an investment, but also the risk of losing money if things don’t work out.

What is Leverage in Real Estate
What is Leverage in Real Estate? | Buttonwood

Leverage allows you to purchase properties outside of your price range or multiple properties with little cash in hand.

You can leverage a property by borrowing cash from a lender rather than paying the whole purchase price yourself.

READ MORE: How to Be a Good Real Estate Agent: Tips and Tricks for Success

Benefits of Leverage in Real Estate

Using leverage in real estate investing has several benefits, such as:

1.Higher returns

Leverage can boost your returns by allowing you to buy more properties or more expensive properties with less money.

For example, if you have $100,000 and buy a property for $100,000 with no leverage, your return will depend on the appreciation and rental income of that property.

But if you use 80% leverage and buy a property for $500,000 with $100,000 down payment, your return will depend on the appreciation and rental income of five times the value of the property.

2.Tax advantages

Leverage can reduce your taxable income by allowing you to deduct the interest expenses on your mortgage.

For example, if you pay $20,000 in interest on your mortgage in a year, you can deduct that amount from your rental income and lower your tax liability.

3.Diversification

Leverage can help you diversify your portfolio by allowing you to buy different types of properties or properties in different locations with less money.

For example, if you have $100,000 and buy one property with no leverage, you are exposed to the risk of that property and its market.

But if you use 80% leverage and buy four properties with $25,000 down payment each, you are exposed to the risk of four different properties and markets.

Risks of Leverage in Real Estate

Using leverage in real estate investing also has some risks, such as:

1.Negative cash flow

Leverage can increase your expenses by adding the monthly mortgage payments to your operating costs.

If your rental income is not enough to cover your expenses, you will have a negative cash flow and lose money every month.

For example, if you buy a property for $500,000 with 80% leverage and $100,000 down payment, and your monthly mortgage payment is $2,000, you will need to generate at least $2,000 in rental income to break even.

If your rental income is less than $2,000, you will have to pay the difference out of your pocket.

2.Higher risk of default

Leverage can increase your risk of default by making you more vulnerable to market fluctuations and unforeseen events.

If the property value drops, the rental income decreases, the vacancy rate increases, the interest rate rises, or the economy slows down, you may not be able to make your mortgage payments and lose your property to foreclosure.

For example, if you buy a property for $500,000 with 80% leverage and $100,000 down payment, and the property value drops to $400,000, you will have a negative equity of $100,000 and owe more than the property is worth.

If you can’t sell the property or refinance the mortgage, you may have to default on the loan and lose your property and down payment.

3.Lower flexibility

Leverage can limit your flexibility by tying up your cash and credit in long-term commitments.

If you use leverage to buy a property, you will have less cash and credit available to buy other properties or to deal with emergencies.

You will also have less control over the property, as you will have to follow the terms and conditions of the lender.

For example, if you buy a property for $500,000 with 80% leverage and $100,000 down payment, you will have only $100,000 left in cash and credit, and you will have to pay the mortgage for 30 years.

You will also have to abide by the lender’s rules, such as maintaining a certain level of occupancy, insurance, and maintenance.

How to Use Leverage in Real Estate Wisely

Using leverage in real estate investing can be a powerful tool to grow your wealth, but it can also be dangerous.

Therefore, you need to use leverage wisely and responsibly, by following some best practices, such as:

1.Do your due diligence

Before you use leverage to buy a property, you need to do your homework and research the property, the market, the financing options, and the risks involved.

You need to analyze the cash flow, the appreciation potential, the vacancy rate, the competition, the demand, the supply, the taxes, the fees, and the legal issues of the property.

Compare different lenders, interest rates, loan terms, and fees, and choose the best financing option for your situation.

You also need to assess your own financial situation, goals, risk tolerance, and exit strategy.

2.Have a cushion:

When you use leverage, you need to have a cushion of cash and credit to cover the unexpected expenses.

You need to have enough cash reserves to pay for at least six months of mortgage payments, operating costs, repairs, and vacancies.

Have enough credit available to access more funds if needed.

Having a cushion will help you avoid negative cash flow, default, and foreclosure.

3.Don’t over-leverage

When you use leverage to buy a property, you need to be conservative and realistic, and don’t over-leverage yourself.

Avoid buying expensive properties than you can handle, and don’t borrow more money than you can repay.

You need to have a comfortable debt-to-income ratio, a healthy loan-to-value ratio, and a positive cash flow.

Diversify your portfolio and not put all your eggs in one basket.

Over-leveraging can lead to financial stress, bankruptcy, and ruin, so you need to be careful and prudent.

Conclusion

Leverage in real estate is the use of borrowed capital or debt to buy properties that can generate more income.

It is a technique to increase the potential return of an investment, but also the risk of losing money if things don’t work out.

Leverage can have many benefits, such as higher returns, tax advantages, and diversification.

Therefore, you need to use leverage wisely and responsibly, by doing your due diligence, having a cushion, and not over-leveraging yourself.

Leverage can be a powerful tool to grow your wealth, but it can also be a dangerous trap to lose your money.

 

Leave a Comment