Real Estate Leverage 0
Leverage is a way to acquire real estate that is worth more than the asset or equity of the investor to increase wealth. The investor usually leverages his asset or equity through a mortgage. The return on investment of real estate significantly increases the wealth of the investor.
A key to successful real estate investing is leverage. Leverage allows an investor to use a small amount of cash to generate large returns. Here is an example of how it works: A hypothetical investor purchases real estate worth $100,000. The investor puts down $20,000 cash and borrows the difference ($80,000). If the investor later sells the property for $120,000 (a 20% gain) and pays off the $80,000 loan, he or she is left with $40,000. This represents a 100% return on the original $20,000 investment. A 20% gain on the sale of the property was leveraged into a 100% gain on the cash invested. Of course, this is an oversimplified example used to illustrate the meaning of leverage. We did not discuss income and expenses as well as other costs, such as real estate transaction fees, loan interest, commissions, or the holding period (one year, two, or more), but the concept is accurate.
Leverage works better with real estate investments than other kinds of investments because it is easier to borrow money against real estate than other assets. Leverage also works for stock investments using a margin account, but the rules are very stringent because the stock is not a tangible asset. Land (real estate) will always be there, and they are not making any more. Creditors are eager to lend money to borrowers for real estate purchases because such loans are secure.
Not everyone who invests in real estate is successful. It has been known for real estate values to fall rather than rise. Like other investments, real estate values move up and down and in market cycles. When investing in real estate, it is important to have a long-term strategy because you may have to be in it longer than anticipated in order to realize your investment goals, if at all. Leverage works both ways. If the investor above had sold the property for $90,000, they would have suffered a 50% loss on their $20,000 investment despite the fact that the decline in value was only 10%. Furthermore, the lender was paid in full for the loan—despite the real estate loss.
Avoid these high risk behaviors and you have a far better chance of realizing success in using real estate leverage:
Don’t Count on High Levels of Appreciation
Many a real estate investor has gotten into financial trouble by looking at past history, even if recent, and relying on the future to produce the same results.
Even if property has been appreciating at a 12% to 20% rate for a number of years, counting on that rate to continue is an extremely risky proposition. It can cause you to overpay for properties, expecting to realize the difference at sale from appreciation. If it doesn’t happen, you’re holding a loss or worse.
Don’t End up With Too High a Payment
It can seem like a great investment to control a property with a very small down payment. You’re looking at the numbers and seeing a really high return on investment due to your low cash outlay.
The problem is the higher payments that come with higher leverage. Should the market soften or your properties experience higher-than-expected vacancy or credit losses, you could find yourself unable to maintain those higher mortgage payments that seemed fine at the beginning.
Don’t Let Good Financing Result in a Bad Purchase
Many an investor has overpaid for a property because they found nirvana in a high leverage financing setup. Just because you can get a property with very little cash outlay doesn’t mean that it’s a good buy. Look at the value of the property in the context of current and expected market trends.
If the property is overpriced, appreciation will be minimal or worse be non-existent. And woe be unto you if the market retraces itself for a while. Your overpriced property will be a significant drag and you’ll not be able to unload it without taking a loss.
Don’t Forget That Cash Flow is King
If just one of these “don’t” behaviors sticks in your mind, this is the one that you should consider carefully. Errors in judgement in one or more of the other items here can be overlooked if you have that one great thing - excellent cash flow.
If your rental income minus your mortgage costs and expenses is putting a nice cash return in your pocket every month, then the fact that the property didn’t gain in value this year won’t be as worrisome of an event.
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