Are you looking to expand your real estate investment portfolio? Let’s discuss leverage, which is one of the best ways to invest in real estate.
Before digging into leverage, though, it’s important to understand what home equity is—because that is what you’ll be leveraging to increase your real estate portfolio. In short, home equity is the value of a house minus the outstanding mortgage on the property. If your property is worth $250,000 and you owe $100,000 on the mortgage, you have $150,000 in equity. The more equity, the higher your return on investment (ROI).
Real estate investors often use leverage to buy more than one property. That’s because the more real estate leverage an investor employs, the more they can build wealth. Leverage provides other benefits to real estate investors, such as diversifying their investments. Investing in both commercial and residential real estate, for instance, can be a boon during a recession.
Now that you understand equity, let’s talk more about leverage.
What does it mean to leverage your real estate?
You may be asking yourself, “What is real estate leverage?” In simple terms, real estate leverage is when you use debt to expand your potential return on investment.
Basically, it means you borrow money from a lender to purchase a property.
By leveraging real estate, you can afford more real estate investments than using your own money. By using a lender, you can now use leverage to purchase multiple investment properties.
How does leverage work in real estate?
Let’s say you want to leverage your primary residence to start a real estate empire. Your lender allows you to borrow up to 80% of the home’s worth through a home equity line of credit (HELOC).
In this scenario, you have a $250,000 home, so you can borrow up to $200,000. Subtract the $100,000 you currently owe on the mortgage, and you have $100,000 to invest. You could use this to purchase a rental property outright.
Congratulations—you just leveraged property to increase your portfolio.
If the value of your $100,000 investment property goes up by 5% in a year, it will be worth $105,000. Thus, your net worth will have increased by $5,000.
Taking advantage of leverage lets you increase your return. Instead of buying a $100,000 property outright, you could use that money as a 20% down payment for a $500,000 property. After 12 months, let’s say the value goes up by 5%. Your real estate investment is now worth $525,000, and your net worth has increased by $25,000. That’s $20,000 more than if you had purchased the $100,000 property outright.
Boom: The power of leverage.
Why use leverage in real estate?
A common myth is that all debt is bad debt. When you typically think about debt, you don’t get a warm and fuzzy feeling, right? You probably have a negative reaction and think about debt collectors. However, real estate debt is just the opposite; instead of a loss for you, it’s actually a gain.
Managing equity properly can be a positive lever, especially if used to compound wealth rather than consumption. Having equity in your property doesn’t necessarily enhance net worth. However, accessing that equity can, especially if used to accelerate your other resources to cover your debts.
This leverage form of debt works to your advantage in a rising market. If you have the time, finances, and patience to wait out a falling market, you will be rewarded with a successful investment when real estate markets are strong.
Essentially, you can put little to no money down and generate an increase on your investment return while waiting out a crashing market.
More on leverage from BiggerPockets
How does leveraging real estate build wealth?
People are familiar with the concept of investing in the stock market to generate a return. If you invest $100,000 in the stock market, you are paying that money in cash upfront. To double your money, the stock has to increase by 100%.
However, a real estate investor with a goal of leveraging real estate to build wealth may choose to put down only $20,000 on a $100,000 investment. That house only has to appreciate by 20% for you as the investor to double your money.
Everyone starts in different places. If you have never bought a house, buying your first with a value-add is an effective way to get started. (A “value-add” is when you work to increase the property value—usually through renovation.) You learn the buying process and you get to make your first purchase with an investor mindset. If you already own a house, then you may have equity in it, or you may be able to refinance to get some of the cash out at a low interest rate.
If you have a house with equity, but you can’t access the equity—for example, because you haven’t reached the 20% minimum equity needed for most cash-out refinances—now might be the best time to sell. Many markets are currently inflated, and if you’ve been living in the house for two years, the gains are tax-free. From equity to selling to HELOCs, there are lots of options available. Make sure you take the time to consider them all.
If you have equity that you can borrow against, then a HELOC acts like a credit card against your house. It uses the existing equity you have in your house, which allows you to use the funds at your discretion. And just like a credit card, you don’t owe anything until you deploy the capital.
HELOCs are a highly recommended strategy for buying more property.
What are the benefits of leveraging real estate to build wealth?
Along with increasing your potential ROI, there are other reasons to consider leveraging real estate.
- Increased monthly cash flow: You might have enough cash on hand to buy one real estate investment outright. Through leverage, though, you can buy more properties and generate more rental income.
- Increased tax deductions: Real estate investors can often deduct mortgage payments and rental property improvement expenses from their taxes. The more real estate investments you have, the more you can deduct.
- Diversity decreases risk: Leverage enables you to buy more rental properties—ideally in different classes—which can insulate you from the dangers of real estate investing.
What are the risks of leveraging real estate?
While leveraging real estate can be an excellent way to build wealth, it’s not risk-free.
1. Risk of foreclosure
When you leverage your real estate, keep in mind a lender will hold a lien, which is a mortgage or a deed of trust against your property. The lender thus has the power to foreclose on your property if you default on your loan, which means you would lose everything you invested into this property.
2. Lender terms
Decide carefully who you do business with.
When leveraging real estate, investors do not have consumer protection because real estate loans are considered business loans. You want to steer clear of any lenders who seem dishonest or unethical. High interest rates are a red flag, as are unfair lender terms or hidden fees in the fine print of your contract.
What if the value of your property depreciates instead of rises? If this happens, you’ll owe more than your property’s worth. This is definitely not building wealth as you intended.
For example, let’s say the value of that $500,000 property goes down 5% in your first year of ownership. Your $100,000 investment is now worth $75,000, and your net worth has dropped $25,000.
If you bought a $100,000 house in an all-cash purchase, a 5% drop would decrease its value by $5,000. Yes, your net worth still decreased—but that’s better than losing $25,000.
4. Loss of rental income
Your finances can take another hit should rents fall alongside property values. Keep in mind that your rental properties’ value is directly based on what rates you can charge your tenants. Tenants will pay less in a decreasing and competitive market, which means your income decreases. If this happens, you may not have enough monthly income to make your mortgage payment, and you might take a loss on your investment if the situation does not improve quickly.
This is an example of overleverage, which means you owe more on your loan than your monthly cash flow brings in. For instance, let’s say that you have two properties with monthly mortgages totaling $2,000. If your monthly rental income drops to $1,500, you’re now overleveraged by $500 a month.
Of course, the more properties you leverage, the bigger the hit you’ll take. Leveraging more real estate can multiply your ROI through housing appreciation, but the inverse—depreciation of assets—is true, too. Your net worth falls if you own one depreciating property and obviously falls even faster the more depreciating properties you own.
Keeping in mind the risks, leveraging real estate to build wealth is still an excellent financial investment. By minimizing these dangers, you can potentially grow your net worth and your real estate investing business.
As the saying goes, there’s no reward without risk.
Be thorough in your due diligence. Check out an investment property carefully and the reputability of your lender. If the market is not headed in the direction you would like, be willing to wait long-term for it to go back up again.
After all, when it comes to the real estate market, what goes down must eventually go back up. You may have to be a little extra patient when leveraging real estate to build wealth. But that doesn’t mean leveraging is a bad idea because the increased financial benefits tend to outweigh the risks in this type of investment.