Leverage, also known as debt financing, offers a useful tool for real estate investors. Leverage allows you to effectively increase your buying power which ultimately increases your properties and your chances to maximize the return on your investments.
Unfortunately, leverage can also end up working against you if it’s not used wisely. Investors should use caution when employing high leverage as part of their investing strategy. This article offers a useful introduction to the nature of leverage financing, as well as other benefits and potential risks.
The Benefits of Leverage
As mentioned above, leverage is an investment financing strategy designed to maximize the potential returns on your real estate investments. At its simplest level, leverage can allow you to make a higher stakes investment by buying more properties, thus increasing your potential payout. This is because leverage usually costs an investor less than the return that an unleveraged property would generate.
If that sounds a little confusing, don’t worry. A simple example should help you to understand the benefits of leverage. Say that you have $1 million to invest in a property. Opting for a 50 percent leverage will give you the financial power to purchase a building valued at $2 million. Yet if a second investor opted for a 75 percent leverage, they would be able to buy a $4 million building.
Now let’s assume that both of those hypothetical properties appreciate by 10 percent over the course of a year, at which point the two owners choose to sell their buildings for profit. Although both started out with the same $1 million, the second investor will make twice as much money — i.e. $400,000 compared to the $200,000 made by the first investor.
The Drawbacks of Leverage
Now that you know the benefits of leverage, lets discuss some of the potential drawbacks. It’s a fact that some investors always try to obtain as much leverage as possible. Yet higher leverage also increases your potential risks and monthly payments. If properties fail to appreciate at the expected rate you may find yourself with smaller-than-expected returns or no profit at all. When it comes to apartment buildings, having a high vacancy rate puts you in a situation where you will end up making payments to your lender without the benefit of having the cash-flow to offset the debt.
Even worse, if property values drop, as they did during the 2008 real estate market crisis, you may end up “underwater” with a mortgage balance higher than the actual value of your property and even default on the property. The higher your leverage rate, the more susceptible you are to such losses and market conditions.
Experienced residential investors realize that while every property may not make money, especially in the short term, using appropriate leverage to diversify your portfolio can eventually reduce your overall risk from vacancy loss, decline in value, capital improvements, etc.
Using Leverage Wisely
How can you use leverage wisely? Well to a certain degree, investors can mitigate the risks of leverage by means of certainty of execution. All lenders have guidelines on how much they will lend out and most lenders will not go above 80% or 85% loan to cost. Some lenders will offer up to 90% or 95%, that doesn’t mean that you should take out a loan for the maximum amount or go looking for these specialty lenders. Look for deals that could be 60-80% leverage to start out, this allows you to have some financial room for economic changes or unexpected cost. Run the numbers and play out different financial scenarios.
As you diversify and grow your investments, you’ll be able to take some measurable risk and maybe take a higher leveraged property on but always run the numbers. What would happen if rents fall or you have a high vacancy rate for a couple months, what does that scenario look like for you as far as being able to make your monthly payments. In other words, you cannot count on rental income to cover your mortgage with the same degree of assurance all the time. Because of this, it would be wiser to approach your investment with a smaller amount of leverage to begin with.
The key to wise investment financing is to avoid over leveraging, thus allowing you to stay safely ahead of payments and building a solid business for decades to come. You’ll also need a strong relationship with a lender that can help you finance future properties and can structure deals with you for the long run.
As a private lender, Center Street Lending, provides residential investment loans but we also do more than just loans, we add value to our investors by sharing our real estate experience and market insights to help you succeed for years to come. We work with you to structure a loan that makes sense and our Loan Origination Managers and Executive Team is available to help with any question you may have. Center Street Lending takes pride in developing long-term relationships with our clients. In fact, a majority are repeat customers due to our professional service, financing counsel, and attractive loan terms. Let us help you finance your next deal! Contact us today at (866) 601-2813.