As an investor, you're always looking for the next big thing. The stock market is too slow and over-saturated with new investors to make a profit, commodities are too volatile and risky, and real estate is too complicated and not liquid enough.
But what if there was something that could combine all of these things? Something that would allow you to invest in different real estate markets without having to go through the trouble of opening up accounts at every single one?
Welcome back! In today's blog post, we’ll be discussing leverage and how to use it effectively as a real estate investor. Using leverage can be confusing if you don't know what it does, so let's start by defining it.
What Is Leverage in Real Estate Investing?
In a nutshell, leverage is when you use borrowed money or fiscal instruments to buy an asset - to increase your return on investment. When you invest in property, you must be aware of any potential financial risks and manage them. If you're not careful, investing with too much leverage could create a dangerous situation for your long-term financial security.
In most cases, you can borrow up to 80 percent of the purchase price from a mortgage lender, and you only have to come up with the remaining 20 percent from your funds. That means, if you are buying a property worth $5 million, the lender will have a look at the rental property, the rental income, and your personal credit.
If the loan is approved, the lender provides the 80 percent ($4 million), and you pay the 20 percent ($1 million) with your own money.
With real estate leverage, real estate investors can build wealth and take part in real estate investments without having much cash on hand. Real estate leverage also allows real estate investors to spread their assets across a number of rental properties.
Note that to leverage a real estate investment you’ll need to obtain extra funding from one of the lenders listed below.
- Credit unions
- Private money lender
- Hard money lenders
Types of Leverage in Real Estate
Now you know what leverage is and how it works. There are several ways to leverage an investment property and make more rental income. Let's dive in!
1. Traditional Mortgages
It's normal to see most real estate investors going down this road because traditional mortgages are standard among primary residences.
On the bright side, traditional mortgage lenders offer reasonable rates and fees. You can also use owner-occupied financing with a minimal down payment and cheaper interest rates if you house hack.
On the other hand, traditional lenders file credit reports with the credit bureaus. This lending system may not be problematic at first, but note that these lenders have the authority to cut down on the number of mortgages that can appear on your credit history.
They usually limit you to four mortgages, establishing a clear limit on how many mortgage payments you need to make.
2. Portfolio Loans
When traditional banks sell off their loan portfolio, it's often because they have to. That isn't the case with portfolio lenders who can keep loans on hand for extended periods of time to accommodate changing customer demands.
Portfolio lenders are faster, flexible, and offer adjustable-rate loans more often than traditional lenders. These lenders base their decisions on the quality of your deal and don't often verify your income.
Before choosing a portfolio lender, make sure to compare interest rates and loan terms.
A home equity line of credit (HELOC) can be used to finance an investment property. A HELOC is a rotating line of credit secured against a property.
Think of a HELOC as a credit card that you can use, but you'll lose all of your real estate investments if you default.
You can use a HELOC to finance your next property, pay for renovations, and cover several other expenses. The good thing about this system is that you can make your loan payments at your own pace.
4. Business Credit Lines & Cards
You can qualify for business credit cards and credit lines as a property investor. A
Business credit cards and credit lines aren't secured against any of your properties, so you don't risk losing any of your investments, plus you don't have to pay for title searches and record liens.
Like HELOCs, you can use these credit lines to finance your next property, pay for renovations, and cover several other expenses. Using business credit allows you to settle the balance at your own pace, with low minimum monthly payments.
5. Private Notes
Most property investors who have been in the business for a long time raise money through notes rather than lending services.
A "note" is simply a legal document that a borrower signs to guarantee repayment of a loan. Private notes are exactly what they sound like: a personal loan between two people. This system means that you can borrow money from a friend, colleague, or other real estate investors.
You might ask yourself why anyone would want to take such a loan. Number one is flexibility, and you can easily negotiate the interest rates, loan payment method and schedule a payment time that benefits both parties.
As you gain experience and prove to friends that you can keep your part of the deal, most of your family and friends will be more willing to lend you additional funds with no upfront fees.
Why Use Leverage in Real Estate Investing
Why leverage real estate in the first place? Many real estate investors have asked this question and the simple answer is that the best way to diversify your real estate portfolio is to use other people's money (OPM).
Property investment comes with its risks and rewards, and aspiring investors know that nothing comes easy in the real estate market.
Here are some of the benefits of leverage in real estate investment.
Higher Investment Reward
Every real estate investor knows that a leveraged property comes with its own risk and rewards. When the interest you pay on your investment loan is less than the rate of return on the investment, you can use leverage to boost your returns. This practice is also known as a cash-on-cash return policy.
A cash-on-cash return is the difference between your investment cash and the amount you get after your mortgage payment and expenses are deducted.
Consider this: You buy an investment property worth $400,000, rent it out for $3000 per month, and after the interest rates have been deducted, you take home $1500 monthly. That means you'll make $18,000 yearly, and you bag a return of 7.5%.
One of the advantages of leveraging real estate is that it allows you to diversify your portfolio by purchasing several investment properties.
Now imagine that you wish to invest in real estate with a friend. You both have $400,000 in your bank accounts. Your friend pays cash for one property, but you take out real estate loans to purchase five identical properties.
Now imagine you invest in real estate with a friend. You both have $400,000 in your bank accounts. Your friend pays cash for one property, but you take out real estate loans to purchase five identical properties. This way, you’ll be able to get more for less and higher investment returns.
At the end of the first year, your friend will have an annual net income from just one property, while your five properties will give you double his net earnings.
Note that property values appreciate over time, so expect to walk home with additional income each year. Now imagine that the properties appreciate at a rate of 4% each year on average. After ten years, each of your five properties will have double the appreciation benefits of your friend’s investment, and you who invested in multiple properties will have more funds to keep reinvesting.
Leveraging real estate has several advantages, and equity build is another huge advantage. When you buy a house for the first time, your equity is restricted to the amount of money you put down. Over time, as the income from the property pays down the principal on your loan, you'll be building equity that your tenants will be paying for.
Better Tax Rates
Real estate investing has several tax benefits. Leveraging real estate allows you to take advantage of the tax deductions and depreciation on an amount much higher than your invested cash.
You can depreciate the overall cost of the property and the money you put into it when you leverage an investment property—that way, you get significant tax deductions each year.
What Should You Look For in a Real Estate Leverage
If you want your investing career to last for a long time, then know that investment leverages are not always ideal. Every lender has its interest rate and conditions. Here are some factors to consider before choosing investment leverage:
Some private and public money lenders are out to suck you dry. Some lenders charge high mortgage costs, rates, and fees, and some money lenders may even charge you as high as 12%.
If you're considering a high-interest loan, make sure the deal you're working on gets completed within 12 to 24 months. High-interest loans are best for short-term deals, and if you decide to take one out, make sure you can afford the repayments.
Property appreciation and depreciation are common in the real estate business. If you’re looking to be an active real estate investor, getting a long-term loan that allows you enough time to pay back should be your top priority.
Short-term loans can last from six to twelve months, while long-term loans can last from five to ten or even twelve months. Before accepting the loan, make sure you meet the lender's requirements and pay the money back when it's due.
A lender imposes a prepayment penalty if a loan is repaid early. Consider this as a lender's insurance where the lender fines you when they don't earn their expected return on the loan. If you think you'll be able to repay the loan and cover the penalty fee, be sure to add that to your costs
Make sure to check what loan fee the lender is charging, as some fees might catch you off guard. Note that some costs are either integrated into the loan or levied upfront. There could be hidden charges such as a broker fee, small fees that accumulate to a large amount, or just two hefty fees.
Be sure to double-check the loan terms and find out what fees will be levied upfront. This way, you can easily calculate all your costs.
Nobody likes a bad property investment, so It is natural for a lender to set terms to try and protect their assets. Moneylenders approve loans based on the annual net income of the investment. You may find that a lender will require a certain amount of money to be paid into an escrow account every month as reserves for significant repairs.
Some lenders will also require you to submit annual financial statements for the property. Such documents are usually accompanied by a requirement to earn a certain amount of money. The lender has the power to seize your property if you fall below the minimum payment amount for an extended period.
Lastly, double-check the required income on the property and make sure it is reasonable.
Frequently Asked Questions (FAQs)
What Are the Risks of Using Leverage?
The risks of using leverage are significant. If you don’t have the money available to pay back a loan, that can ruin your credit score and can make it difficult to acquire loans in the future. Also, money lenders have the power and right to seize some properties or assets of people who default on their loans.
Additionally, the fluctuations in real estate values might also hit hard. If the value of a property falls, your account may slip into the red within hours, resulting in a significant loss. In this situation, repaying the moneylender could be challenging.
When you're looking into an investment, it's crucial to run a thorough check and ensure that the rates are favorable. You might even want to do your research on what interest rate will fit best with how much risk is involved. After all, you can never be too careful!
Overall, leverage is a valuable tool and helps investors own multiple properties. As long as you have carefully strategized and put a backup plan in place, leverage will help you build wealth and scale your portfolio.
Is Financial Leverage the Same as Real Estate Leverage?
Both financial and real estate leverage are similar in that they involve investing with other people's money. Financial leverage involves using other people's money to buy assets in the hope that the net income from the new investment deal will exceed the cost of borrowing.
In most cases, the moneylender will set certain conditions to limit the number of investment risks it is willing to handle and how much money it can give out.
Is Real Estate Debt Bad?
Owing people money is never a good idea, and it could land you in lots of financial trouble.
But if you are focused on the financial benefits of leveraging real estate, then note that leverage will do you more financial good than harm.
The question "What is leverage" has been popping up on several threads. Leverage in real estate is simply using other people's money to buy and invest in properties. With the fluctuations in real estate prices, leverage allows an investor or someone looking to get started in real estate to purchase multiple rental properties with little cash in hand.
How much money you make depends on the property type and the number of properties you invested in.
Join thousands of real estate investors who have started to build wealth through short-term rentals.