Investing in real estate has become a popular way to diversify your investment portfolio. Everywhere we look, we're constantly reminded of the benefits of buying property, from the many infomercials about real estate seminars, or the home shows that tote the incredible value of managing or flipping rental properties.
But it isn't that easy. After all, buying a rental property isn't like investing in stocks—you can't just put down a little here and there and become a property owner. You need capital to make that purchase. And the process can often be long and drawn out. Not to mention all the risks involved, especially if you don't do your research. But is there a way to get into the market by increasing your net worth? Try using leverage to your advantage. By doing this, you can put little to no money down, and use debt to help you realize a return.
- Leverage uses borrowed capital or debt to increase the potential return of an investment.
- In real estate, the most common way to leverage your investment is with your own money or through a mortgage.
- Leverage works to your advantage when real estate values rise, but it can also lead to losses if values decline.
- Avoid leveraging risks by making sound investment decisions and accounting for mortgage payments, vacancies, and a tough economy.
What Is Leverage?
Leverage is the use of various financial instruments or borrowed capital—in other words, debt—to increase the potential return of an investment. It commonly used on both Wall Street and Main Street when talking about the real estate market. Leverage is a technique used by both people and companies to expand the potential for returns, while equally expanding the downside of any risks involved if things don't work out.
While the potential for a good return is possible—like when real estate prices rise—using leverage can be a double-edged sword. That's because it can also lead to losses if the investment moves in the opposite direction. In the case of real estate prices, losses happen when prices decline.
Ways to Access Leverage
The easiest way to access leverage is to use your own money. In the case of a mortgage, a standard 20% down payment gets you 100% of the house in which you want to live. Some financing programs let you put even less money down.
If you purchase the property as an investment, you may be in a position where your partners furnish some—or even all—of the money. Similarly, some sellers may be willing to finance some of the purchase price of the property they wish to sell. Under such an arrangement, you can purchase a property with little money down and, in some cases, no money down at all.
Leverage: Increasing Your Real Estate Net Worth
Example of Leveraging
Consider the common real estate purchase requirement of a 20% down payment. That's $100,000 on a $500,000 property. By putting down only 20% of the money down and borrowing the rest, the buyer essentially uses a relatively small percentage of his or her own funds to make the purchase. The majority, therefore, is provided by a lender. That's why real estate investors often refer to the remaining 80% of the purchase price as other people's money.
Let's assume the property appreciates at a rate of 5% per year. This means the borrower's net worth grows to $525,000 in just 12 months. Comparing this gain to the gain from a purchase made outright, without any loan, highlights that value of the leveraging strategy. For example, the same borrower could have used the $100,000 to make a paid-in-full purchase of a $100,000 property.
Assuming the same 5% rate of appreciation, the buyer's net worth from the purchase on an all-cash $100,000 property would increase $5,000 over the course of 12 months, versus $25,000 for the more expensive property. The $20,000 difference demonstrates the potential net worth increase provided through the use of leverage. Now, picture that 5% gain every year for 20 years. Over time, the use of leverage can have a very significant and very positive impact on your net worth.
The Dangers of Leverage
Now for the bad news. All this sounds great, but there's a downside. Leverage can work against you, just as much as it can work in your favor. To show how, let's revisiting our earlier example. If you use a $100,000 down payment to purchase a $500,000 home, and real estate prices in your area decline consecutively for several years, leverage works in reverse. After year one, your $500,000 property could be worth $475,000, if it depreciates by 5%. If prices continue on that same trajectory, soon your property could be worth $451,250—a loss in equity of $48,750.
Just as leverage can work in your favor, it can also work against you.
Under that same 5% price-decline scenario, if that $100,000 was used for an all-cash purchase of a $100,000 home, the buyer would have lost just $5,000 the first year home prices fell—much less than that more expensive home.
In real estate markets where prices fall significantly, homeowners can end up owing more money than the house is actually worth. For investors, declining prices can reduce or even eliminate profits. If rents fall too, the result can be a property that cannot be rented at a price that will cover the cost of the mortgage and other expenses. If you are contemplating becoming a landlord, there are many factors to consider.
Cons Leveraging Many Properties
The problems get even bigger when multiple units are involved, as commercial real estate investors often put down as little money as possible. The goal is to leverage your money by taking control of 100% of the assets while only putting down 20% of the value. Consider the $500,000 in our previous example. only let's say it's a small apartment building. Since it was purchased with $100,000 as a down payment, if the value of the building declines by 30%, the property is worth just $350,000, but the investor still must pay interest and principal on the full value of the $400,000 loan.
Should the amount the investor gets in rent decline too, the result could be default on the property. If the investor uses cash flow from that property to pay the mortgage on other properties, the loss of income could produce a domino effect that can end with an entire portfolio in foreclosure over one bad loan on one property.
Avoiding Leveraging Risks
Now that you've learned about the basics of leveraging in real estate as well as some of the pitfalls, you may think it's impossible to make a good return using this technique. Don't fret—it's just a matter of using common sense. Just like any investment, real estate comes with risk. Although you can use leverage to your advantage, there are a few key things you want to make sure you avoid to give you a better edge in the market.
First, don't assume what will happen before it happens. You can't always use past performance as an indicator of what will happen in the future—especially with the housing market. If you see that property values have risen in a specific area by 5% to 10% over a certain period of time, that doesn't mean they will continue on the same path.
Next, budget yourself accordingly and know what you're getting into. If you put down a lower down payment, the amount of your loan will be higher. That means you'll have to make a larger mortgage payment. You may have to account for lower vacancy rates, a tougher economy, bad tenants—all of which will fall on you. Ultimately, you're still responsible for the mortgage payment, so you have to make sure you can keep yourself afloat in any situation.
The Bottom Line
Images of such leveraged purchases bring to mind those late-night infomercials where smooth-talking pitchmen suggest that you can earn millions of dollars buying properties with no money down. While it is possible, we don't recommend going this route.
Happily, you don't need to. Less exotic ways to use leverage do exist, enabling you to buy real estate with a relatively small amount down—even no money at all. In fact, although they may not think about it as leverage, most people do so if they take out a mortgage when they buy a home. They pay back the loan over a period of years or decades, while enjoying the use of the property. The moral of the story is that leverage is a common tool that works well – when used prudently.