How to use Leverage in Real Estate?
In order to be successful in Real Estate, you need to know this concept of Leverage. And you need to know how to use leverage in Real Estate, simple as that.
What is Leverage in Real Estate?
Leverage in financial terms is borrowed capital, basically a Debt. Leverage is when you borrow money from the bank or an investor in order to increase your potential return on investment.
In simple terms, leveraging is using “other people’s money” to acquire an expansion on possible Return on Investment (ROI) than the leveraged amount.
Leverage is used by both individual investors and companies.
Example:
You have a total of just $100,000 in your bank account. But you can still buy a property worth $500,000 by putting a down payment of 20%. The lender i.e., the bank provides the rest.
By putting down 20% and borrowing the rest, you’re using a small percentage of your own money to make the purchase. You now own an asset worth 5 times more than you could’ve by putting your own money.
This is the power of leverage.
The Power of Leverage in Real Estate
Leverage is simply a debt or when you use debt to buy more.
Let’s continue with the same example, you had $100,000 in your bank account and you intend to buy one property without a loan. You paid fully for the property at the price of $100,000, putting only the given total at risk. If the market goes up 5% then you make $5,000. In this case, there is no leverage and you have a property worth $105,000 in a year.
But if you use leverage, a typical real estate purchase of a $500,000 property just cost $100,000 with a down payment of 20%. And you will own a property worth $500,000. If the property’s value appreciates at a rate of 5% a year, then your net worth grows to $525,000 in 12 months.
You can see the differences here, the 5% appreciation in a year would yield a $5000 return on investment against the $25,000. This creates a difference of $20,000 in favor of leveraged property against the other.
Leverage creates an expansion of the return’s potential.
You might want to read this: How to Buy Your First Real Estate Investment Property 2022?
How to use Leverage in Real Estate?
One of the easiest ways to use leverage is by putting down your own money and financing the rest. Financing is putting some portion of your money and borrowing the rest from the lender as a debt. You can use leverage plus borrowed capital, to generate more returns on your assets.
With the concept of a mortgage, a 20% down payment will get you 100% of a property. There are financing programs that will allow you to put even less down.
You can buy properties like rental properties which can be used as a revenue-generating asset. The same monthly rental income can be used to pay back the mortgage as well.
Also, one can use the leverage to gain an extra edge on return on investment. Let’s see one of the scenarios.
Example:
Let’s say you manage to buy a house worth $250,000 with 20% down, i.e., $50,000 of initial payment & $200,000 loan. You do the renovations of it which costs you an additional $50,000. The total investment done for the house is $100,000.
List the house for sale for $400,000. Sold It!
You use the $400,000 to pay off the $200,000 loan, with the $200,000 remaining amount left.
Minus the initial investment of $100,000 (renovation cost + initial invested amount) and then you have a profit of $100,000 on an initial $100,000 investment.
Isn’t it a great return on investment if you can get it?
Pay cash or Finance in Real Estate?
Would you like to pay full in cash or finance it? It’s a common question in real estate, and everyone’s got an opinion.
Some investors/buyers prefer all-cash sales for good reasons, like avoiding interest charges, monthly mortgage payments, and lender relationships.
While others choose to finance for the simple reason that they don’t have enough capital to buy a property all at once or they don’t want to tie up too much capital into each investment property.
That said, real estate investors with all-cash buying power should seriously consider borrowing as much as they can for their ventures—they’ll get an exponential return for their initial investments. Let’s look a little deeper into how that works.
Related: How to Invest in Real Estate as a Beginner
Leveraging – is it worth it?
Truth be told, as a normal individual, nobody wants Debt. They are actually scared of Debt, especially the kind that gathers interest and yields nothing. However, not all debt is bad.
For example, A Home Mortgage, a low-interest debt that provides the borrower with a living space and tax benefits is a good debt that can do so much more.
When you leverage good debt, you’re getting into a powerful real estate investing tool that can transform your first real estate investment into a bona fide real estate portfolio.
The Risks of Leverage
Leverage can work both ways, it can work for and against you. Leverage can be dangerous; it can be a two-way sword.
Beware, because if the investment goes down you will lose twice as much. The greater the leverage, the greater the risk you have.
Historical note: Too much leverage caused the crash of 1929 and the financial crisis of 2008. This is leverage in investment.
Going back to the previous scenario, if you used $100,000 to make a down payment and bought the property for $500,000, and the prices in your area went down for several years, you will experience the backfiring of the leverage concept. Your property will go down to a worth $475,000 in a year rather than $500,000.
On the contrary, if you’d only bought the cheaper property outright worth $100,000, you’d lose only $5,000 which is far less than you would on the more expensive home.
If you’re in a market where the prices are falling, you can find yourself in a situation where you owe more than the property’s worth.
If you’re an investor dealing with declining prices can lower or fully eliminate your profits.
The Bottom Line
Leverage can act as a boon and as a double-edged sword. You have to be smart and careful to use it. It can also give you an enormous return as well as bring you down to the bottom.
