Investing in real estate is one of the best ways to diversify your investment portfolio and build wealth. However, one thing that usually keeps most aspiring investors from buying investment properties is the lack of funds. Real estate investing is capital intensive and most people simply can’t raise enough money to buy income property with cash.
However, one unique benefit of real estate investing is the ability to use leverage to magnify your return. There are many investors that are getting rich in real estate using this strategy. The vast majority, however, don’t know how to use leverage in real estate and end up in financial distress. To learn more about how you can leverage real estate and get rich, read on.
What Is Leverage in Real Estate?
Leverage in real estate is the use of debt borrowed capital to fund a real estate investment. Leveraging real estate allows you to make money in real estate using other people’s money. This technique can multiply your buying power in the housing market. You can purchase a much larger income property and increase your return on investment compared to if you had to pay all-cash upfront. If fact, the less cash you invest, the higher your leverage and return on investment. This comes from rental income and property appreciation. You use only a small percentage of your own funds to purchase an investment property. The majority is provided by your lender.
The most common way to leverage money in real estate is through a mortgage. In the case of a mortgage, paying a down payment of only 20% will get you 100% of the investment property you want to purchase. Some investment loans allow you to put even less money down. Leverage in real estate works to your advantage when property values rise. Your equity grows when the property appreciates. Over time, you can increase your net worth substantially.
Related: Tips for Getting a Mortgage for an Investment Property
Benefits of Leveraging Real Estate
1. Higher return on investment
When you finance rental properties with an investment property mortgage, you are likely to get more return on the money you’ve invested (cash on cash return) than buying with all cash.
2. You get more for less
When you leverage real estate, you can buy more or larger investments than you would by paying all-cash. For instance, instead of purchasing one investment property for $200,000, you could leverage 4 investment properties by paying a down payment of $50,000 for each. You can actually buy one property per year instead of waiting for years to buy one. This translates into higher cash flow, bigger tax benefits, and more appreciation benefits where applicable. Buying multiple rental properties also helps you diversify.
Related: How to Finance Multiple Rental Properties (Yes, It’s Possible!)
Risks Associated with Real Estate Leverage
Before you leverage real estate, you should also understand that it can work against you. For you to leverage real estate investments effectively, property values and rental rates have to be rising. When house prices decline significantly, the investor can end up owing more money than the actual value of the house. If there is a rent decline too, profits can be reduced or eliminated. If the investor relies on cash flow from that rental property to pay the mortgage, it could end in foreclosure.
The rental income may not be able to cover the mortgage costs and other expenses. If multiple units are involved, the effects of negative leverage are even greater. One bad loan could result in an entire portfolio being foreclosed. Therefore, avoiding risks is crucial to ensure that the real estate leverage works for you rather than against you.
Risk Reduction Strategies for Real Estate Leverage
Regardless of the risks of using debt to buy real estate, you can still make a good return using this technique. There is no investment that has no risks. So do not fret. You just have to leverage real estate investments wisely. Here are a few tips to keep in mind.
1. Look for stable and growing real estate markets
As an investor, you need to perform comprehensive due diligence on the target real estate market before buying an investment property. Study the property value trends in that market. Are there any factors that would influence the regional economy for the foreseeable future like closure or establishment of a big company? What is the average rental income that you can earn in this housing market? Can you find and maintain cash flow properties here?
Related: 8 Characteristics of the Best Rental Markets
2. Make sure you can manage the monthly payment
Once you learn to leverage real estate, you shouldn’t fall into the trap of putting as little as possible down. A higher monthly obligation can later be hard to live with. You have to budget yourself accordingly. Try to find a good balance between your mortgage payment and your down payment. You should account for factors like bad tenants, bad economy, and lower vacancy rates.
3. Don’t assume that property values will increase
Even if property values and rents have been increasing in recent years, it still doesn’t guarantee that they will continue on the same path. As a real estate investor, you should be conservative in your appreciation expectation when taking an investment property mortgage. It’s better if you have a slightly lower expectation and build your financial strategy around that. If returns are higher than you expected, it would still be a win.
4. Establish a contingency fund
When you leverage real estate, make sure you form a contingency fund. Having a nest egg can save your investment when the rental income is unable to cover your mortgage payments.
5. Diversification
When you have multiple cash-flowing investment properties, cash flow from the property could help offset the monthly expenses of another. All your eggs aren’t in one basket.
The Bottom Line
Real estate leverage is the biggest factor used by successful investors to accelerate the growth of their portfolios. By leveraging property, you can put little to no money down and use borrowed capital to help realize a return. The idea of acquiring an investment property with less down can be appealing but also very risky. Leverage only works well when used prudently. Learning how to leverage real estate the right way and taking precautions will help you achieve your dream of building wealth with real estate.
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