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Make the Most of Your Leverage

Jan 18, 2022 10:20:00 AM

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In real estate, leverage is your best asset.

Savvy investors utilize leverage to minimize the amount of personal equity put into investments while maximizing their efforts to scale their portfolios.

To put it simply, leverage is borrowed capital. 

People utilize leverage in real estate for two primary reasons. The most obvious is a lack of capital, where often times homebuyers or investors put down a downpayment and borrow the rest of the cost of the property. Leverage isn’t always sought for lack of funds, though.

Leverage highlights

  • Leverage uses borrowed capital to increase your profit margins.
  • Leverage is most commonly utilized through a mortgage.
  • Leverage comes with risk if market values decline.
  • Leverage advantages increase with rising property values.

One Example of How to Utilize Leverage

Many investors who could pay in all-cash choose to utilize leverage instead. But why?

Here's a prime example.

A buy-and-hold real estate investor purchases a property in cash at an asking price of $200,000. Another investor purchases a similar property at $200,000, but they opt for a mortgage with a $40,000 down-payment instead.

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Even though Investor B has leveraged $160,000 worth of debt, this is an investment property. The mortgage payments should be covered by monthly rental income.

Over time, Investor B will have effectively purchased a $200,000 property for just $40,000. Their net worth benefits from the full value of the property combined with passive income from the rental. 

While buying all-cash can streamline the home-buying process, the investor is limited by the larger financial commitment.

Therefore, leverage benefits investors by obtaining properties for less personal capital. They can then scale their portfolio more quickly, as the cost of acquisition is less, and benefit from passive income paying for their mortgage over time. 

The Risks of Accessing Leverage

Utilizing leverage, like any strategy, comes with risk. There are specific conditions to keep in mind if you want to effectively use leverage to benefit your real estate portfolio.

1. Property values must be on the rise, and...

2. Rents must be increasing.

Due diligence is key

Know your market, where it has been, and where it is headed. In general, real estate does appreciate over time — but we know that there are times where property values decrease, as in a market crash.

When this happens, borrowers become “underwater” on their mortgages. They owe more than the property is worth.

This is a situation to avoid at all costs!

Still, remember — the amount you pay on a 30-year mortgage today is the amount you will continue to pay, regardless of inflation or the appreciation of your property.

The issue of interest rates

Of course, interest rates are also key when we’re talking about leverage. That’s how banks make their money!

Over the past several decades, we’ve seen interest rates drop to record-low levels. This has, at the same time, caused lending standards to tighten. Financial institutions are taking a bigger risk because their profit margins are smaller.

They want to be sure that those they lend to can pay that money back!

Investors want to ensure that their profit margins outpace the added cost reflected in the interest rate.

Calculating Cash-on-Cash Return

Cash-on-cash return is a percentage that shows how much you’re getting for your money in an investment.

You do this by first calculating cash flow:

Net income - loan payment = cash flow

(You may also include all of your expenses associated with the property.)

Cash flow / cash invested = cash-on-cash return

The cash invested is, in this case, your downpayment. Running these numbers can help you decipher what down payment, amount of leverage, and cash flow are needed to optimize the profitability of your investment.

Calculating cap rates

The capitalization rate, or “cap rate” is another pertinent number to have on hand. It can help you determine the yield of any given investment during initial assessments.

Net income / purchase price = cap rate

Your cap rate increases when you utilize leverage — therefore lowering the purchase price and increasing the yearly profitability of an investment.

The Bottom Linepexels-mart-production-7328486

Utilizing leverage isn’t a strategy that every investor loves, but real estate investors benefit from it in a big way. By minimizing the personal equity you contribute to an investment, you can more quickly scale your portfolio — and increase your wealth-building potential.

 

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