What Is Leverage in Real Estate, and How Do You Use It?
Leverage is one of several strategies for investing in real estate. As an investor you likely want to know, what is leverage in real estate? Knowing how to use leverage in real estate investments, and knowing how it can work for you or against you, is necessary when determining how to get the highest rate of return from the money you're investing.
What is leverage in real estate?
Leverage in real estate is using borrowed money to buy a property. When leveraging a property, you borrow funds from a lender to be able to purchase an investment property instead of having to cover the entire purchase price yourself. Being able to leverage your investment is one of the reasons real estate investing is so attractive.
How does leverage in real estate work?
The idea behind leveraging real estate is to be able to increase your returns by using other people’s money at first, and not having to put as much of your own capital into buying a property. Leverage allows a real estate investor to either purchase a property that costs more than the amount of money they have available or to spread out their cash across multiple properties.
To leverage a real estate investment, you'll apply for financing from one the following types of lenders:
Private money lender.
Hard money lender.
The lender will look at the value of the property, the income the property is expected to produce, and your personal credit to decide whether they will approve the loan and what interest rate and terms they will offer. They'll also determine how much of the purchase price they are willing to finance and how much you will have to pay yourself.
For example, if you're buying a $1 million property and the lender says they will loan 75%, they will lend you $750,000 and you'll have to pay the additional $250,000 from your own funds.
Why use leverage in real estate?
You may choose to use leverage for one of two reasons:
You simply don't have enough cash to purchase the investment property you want.
You want to maximize your returns by putting less cash into each property investment.
Leverage can increase your returns when the interest you're paying on the loan is less than the rate of return on the investment. For example, if the rate of return on an investment property is 8% and you're paying 5% on the loan, you're earning the 3% difference from the lender's money.
When evaluating an investment using leverage, you'll want to calculate the cash-on-cash return. The cash-on-cash return is the net return you will receive from your investment based on the cash you put into it and the net amount you receive after covering all of the expenses and loan payments.
To calculate the cash-on-cash return, you'll subtract the loan payments from the property's net income to determine the actual amount of money you're earning. This is called cash flow.
Net income - loan payment = cash flow
You'll then divide the total annual cash flow by the amount of cash you put into the investment.
Cash flow / cash invested = cash-on-cash return
Purchase price: $1 million
Loan amount: $750,000
Cash invested: $250,000
Annual net income after expenses: $90,000
Annual loan payments: $59,000
$90,000 - $59,000 = $31,000
Annual cash flow = $31,000
$31,000 / $250,000 = 12.4% cash-on-cash return
Now let's look at that same property without leverage to see the difference in the rate of return. To do this, we'll calculate the capitalization rate, commonly referred to as a cap rate.
To calculate the cap rate, you'll simply divide the annual net income by the purchase price.
Net income / purchase price = cap rate
Purchase price: $1 million
Annual net income after expenses: $90,000
$90,000 / $1,000,000 = 9% cap rate
If you were to invest the entire $1 million purchase price yourself, you would be earning a return of 9% on your investment. If you use leverage and only invest $250,000 into it, you would be earning a return of 12.5% on your investment.
You can also read our detailed guide to understanding cash-on-cash returns to learn more about this.
Another huge advantage to leveraging your real estate investments is the equity you will build over time. When you first purchase your property, your equity is limited to the amount of cash you put into the deal. Over time, as the income from the property pays down the principal on your loan, you'll be building equity that your tenants will be paying for.
Using the same purchase as above, with a loan amortized over 20 years at 5% interest, you'll gain an extra $126,430 in equity in five years. At this point, you have four options.
Sell the property and get your original $250,000 back, plus add the $126,430 to the total return of the property. $31,000 cash flow x 5 years = $155,000 in cash flow. $155,000 cash flow + $126,430 equity = $281,430 total return on a $250,000 investment.
Refinance the property at the lower amount to reduce your monthly payments and increase your cash flow. Now instead of making payments on a $750,000 loan, you're only making payments on a $623,570 loan.
Refinance the property at the original $750,000 amount and use the equity you've gained as a down payment on another investment property. This would allow you to purchase a $500,000 property that you didn't have to put any of your own cash into.
Refinance the property at the original amount of $750,000 and take the extra cash to do whatever you want with.
When you leverage your real estate investment purchase, you still get to depreciate the total cost of the property, not just the cash you put into it. This gives you a significant tax deduction each year.
You're also able to write off the interest paid on the loan, which during the first several years is the majority of your loan payment. This provides another great tax deduction each year.
Real estate has some great tax benefits, and leverage allows you to take advantage of the interest deduction and depreciation on an amount much greater than what you've invested.
What are the risks of using leverage?
Real estate leverage also comes with its risks. No matter what happens to the property or what the income is from one week to the next, the loan payments are always still due.
When using borrowed capital to buy a property, the lender will have a lien on the leveraged real estate. This lien is usually referred to as a mortgage or a deed of trust. If you default on the loan, the lender can foreclose on your property, and you can lose your entire investment. In many cases, they may even be able to come after you personally for any money they're still owed after they sell the property.
Another risk of using leverage is being vulnerable to the real estate market. If real estate prices fall, the property value of your investment may end up being less than the amount you owe on it. It's common for loans on commercial real estate to have a term of only five years. If real estate values fall within these five years, you may not be able to refinance the property or sell it to be able to pay the loan off.
Loans that are considered business loans are not federally regulated, so investors don't get the same consumer protection when it comes to real estate loans. Loans for a rental property or for commercial real estate are considered business loans, so less reputable lenders may have unfair terms in the fine print.
What should you look for in an investment real estate loan?
Not all investment real estate loans are created equal. Interest rates, balloon payments, and conditions can vary greatly from one lender and loan type to the next. You should thoroughly understand all terms of the loan before you close on the deal.
Some private money and hard money lenders may charge as much as 12%, or possibly more, on their loans. Loans with high interest rates like this are typically for terms of only 12 to 24 months and are used when a deal needs to be closed quickly or some work needs to be done to the property before a traditional bank will finance it. If you're going to accept a loan with a high interest rate, be sure that you'll be able to make the payments.
Real estate business loans usually have to be paid off within a certain time frame. Some may be as short as six to 12 months, but terms of between five and 10 years are more common. These loans will usually be amortized over 20 to 30 years to keep the payments lower, but the entire balance will be due on a certain date. This is often referred to as a balloon payment.
Before accepting a loan, you should know what your plan is to pay the loan balance when it's due. In most cases, you should be confident that you'll be able to sell or refinance the property before the loan term expires.
A prepayment penalty is a penalty a lender charges if the loan is paid off early. They do this as a way to ensure they will earn their expected return on the loan. A prepayment penalty is usually charged as a percentage of the amount that's prepaid. If you think you may sell or refinance the property while a prepayment penalty would be charged, be sure to factor that into your costs.
Some loans can come with hefty fees that are either rolled into the loan or charged upfront. There may be several small fees that add up to a significant amount, or there could be one or two large fees. There may also be a broker fee that you weren't expecting. Be sure to find out what all of the fees will be upfront to determine how much money you will need to close and how much the loan will actually be for.
Since lenders usually approve a loan on an investment property based on the income it earns, many of them set certain conditions to protect their investment. You may find that a lender will require a certain amount of money to be paid into an escrow account every month as reserves for major repairs. Some lenders will also require that you provide financials on the property quarterly or annually. This requirement usually comes with another requirement that you must be earning a minimum amount. If you fall below that minimum amount for too long of a period, the lender has the right to foreclose on the property.
If reserves are required, factor that amount into your monthly costs. You also want to be sure that the required income on the property is reasonable, and that you're not likely to fall below that amount.
The bottom line
Using financial leverage to purchase real estate can help speed up the process of growing your portfolio and building wealth through real estate, as long as you do it wisely and carefully. Don't take on unnecessary risks just for the sake of getting a deal done. The risks associated with leveraging in real estate have significant consequences and can put you in serious financial trouble if things go wrong.
Be thorough in your due diligence in the investment property you're looking at, and don't be afraid to walk away from a deal if you're not certain it will cover the loan payments. You also shouldn't be afraid to turn down a loan offer if you're not comfortable with the terms.
With the right deals and loan terms, leveraging real estate can give you the ability to invest in real estate in different ways, allowing you to diversify your portfolio. Knowing what leverage in real estate is, how it can for you, and how it can work against you will help you make sure you're maximizing what your money will do for you.