Leverage can be one of the most important aspects of your real estate investments.
Leverage in real estate is the practice of using borrowed capital (debt) to fund real property investments. Leverage helps investors maximize the purchasing potential of their own dollars to finance assets they couldn’t afford to buy outright. Using leverage can help investors increase the potential returns of their available investment dollars, but it’s also not without risk.
Below we’ll take a closer look at how leverage is used in real estate.
Benefits of Using Leverage to Finance Real Estate Investments
Leverage can lead to many potential benefits:
- Increased returns. Investors use borrowed money to earn returns that are oversized in relation to the amount of equity they’ve invested.
- Increased cash flow. Leverage can generate higher returns than all-cash investments.
Here’s an example of two investment scenarios. One investor purchases a $2 million property with $400,000 down and leverages the remaining $1.6 million with a 30-year mortgage at 3.5 percent interest. The second investor purchases the asset outright with $2 million in cash. The annual net operating income of the property is $130,000.
Annual loan payments total $86,000 for the leveraged investor ($1.6 million at 3.5 percent for 30 years), which leaves the investor with a net cash flow of $44,000 per year. The investor’s rate of return ($44,000 year/$400,000 investment) is 11 percent. The cash investor, meanwhile, realizes a rate of return of just 6.5 percent ($130,000/$2 million investment).
Assuming debt increases investment risk but also can lead to higher yield.
|
100 Percent Equity |
80 Percent Leverage |
|
|
Capital invested |
$2,000,000 |
$400,000 |
|
Cash Flow |
$130,000 |
$44,000 |
|
Yield |
6.5 percent |
11 percent |
There also are some important tax considerations that come with using leverage to finance investment properties. Investors who own real property assets can depreciate the full value of those assets despite the fact that they used debt equity to purchase the property. Leveraged investors also can claim mortgage interest deductions, which can further increase the overall yield of their investment capital.
Risks of Using Leverage to Purchase Investment Properties
Financed real estate transactions increase an investor’s risk profile in several ways. Common risk factors associated with taking on debt financing include:
- Amount of leverage
- Interest rate
- Debt and valuation
Investors can manage these risk factors at both the portfolio and property level. Staying within a predetermined leverage profile can help investors from becoming overleveraged to the point where they are unable to maintain monthly principal and interest payments. Rising interest rates can lead to lower property valuations, but rental growth and higher net operating income can negate this risk factor. Lastly, long-term fixed-rate financing can be less risky than short-term high-interest debt financing.
Leverage also can add to an investor’s risk profile at the property level. A few factors to consider include a financed property’s age and unforeseen capital expenditure requirements, length of tenant leases, and concentration of existing property type within a given market.
The Bottom Line
Although leverage can lead to additional risk, prudent investors can strategically manage many of the various risk factors that are associated with debt financing. Leverage provides real estate investors with access to additional capital that can lead to increased portfolio diversification and the potential for higher returns than with all-cash investments.
