Utilizing leverage to invest in real estate is an attractive way to grow your real estate portfolio and improve your cash flow. That said, leverage can be risky, so it’s best to know how to use it to your advantage. When you understand this, you can avoid heavy risks.
Using leverage is a practice that allows you to use borrowed capital—or debt—to increase the prospective return on investment. For instance, instead of covering the entire price of a property upfront on your own, you use leverage by borrowing funds from a lender to buy the property.
The principle reason behind using leverage to buy property is to be able to improve your cash flow as you invest in property, whether you’re sinking your money into a single property or spreading out cash between multiple properties. Investing in real estate can be expensive and risky, so this is a great way to add some flexibility to your cash flow.
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How to get started
Apply for a loan from lenders such as a bank, credit union, private lender, or hard money lender. Based on your personal credit, the property’s value, and it’s prospective income, the lender will approve the loan on their terms and interest rate. They will also inform you about how much of the purchase price they are willing to cover, and how much you’ll need to pay for.
The conditions from one lender and loan to another, including interest, prepayment penalties, loan fees and conditions, can differ greatly. Make sure that you do your research and understand the exact terms of the loan before closing on a deal. Be sure that you can expect a reasonable return from the property to be able to cover all the fees involved in the loan.
Why use leverage to buy real estate?
Leverage can help you buy into properties that you may not have enough money to buy on your own. It also helps to maximize your returns by allowing you to put less money across multiple property investments. By calculating the cash-on-cash return on your investment, you can figure out the actual cash flow created from your investment. Leverage can increase these returns when the rate of return is higher than the interest you’re paying on the loan.
Another advantage of using leverage is that over time, you can also build equity on your property as the income from the property pays for the loan. Real estate also comes with great tax benefits, which you’ll get to fully realize using leverage.
Hazards of leverage
Leverage in real estate also comes with risk. First, it’s key to keep up on your loan payments. If you default on your loan, then there can be serious consequences.
Another serious risk is that your property is vulnerable to the real estate market. Just as there is the benefit of rising real estate prices that could potentially benefit your rate of return, the opposite is also possible. If real estate prices plunge, your property will also lose value, and if you come to the end of your loan’s term without being able to pay the loan off, then it may not be possible to refinance your property.
If you are using leverage in multiple units, then a loss on one property could lead to not having the needed cash flow to pay off the loans on the other properties. This could lead to a domino effect of failed investments.
How to avoid leveraging hazards
All real estate investments come with risk so it’s important to figure in some loss when deciding on a property. Take into consideration the terms of the loan and how much cash you’ll need to make sure that you can make up losses within a reasonable margin.
Leverage is one of the most attractive elements of real estate investment, but you should know how leverage can work for you and against you. It can work to your advantage when values in the real estate market rise, but it can also work to your disadvantage when the market declines. You can avoid risks by doing your due diligence on the loan before signing a deal, and by accounting for reasonable losses and a tough economy in your investment decisions.
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