What Is Real Estate Leverage?
Buying a home with a mortgage is an example of using real estate leverage. That loan helps you buy a house you otherwise couldn’t afford. If the property appreciates, so does your home equity.
Before digging into leverage, it's important to understand what home equity is—because it's 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.
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. And leverage provides other benefits to real estate investors, including diversifying their investments. Investing in both commercial and residential real estate, for instance, can be a boon during a recession.
How Does Real Estate Leverage Work?
If the value of your $100,000 investment property goes up by five percent in a year, it will be worth $105,000, and your net worth will have increased by $5,000.
Taking further advantage of leverage lets you increase your return. Instead of buying a property outright, what if you use your $100,000 as a 20 percent down payment for a $500,000 property? After 12 months, the value of the house goes up by five percent. 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 property outright.
Boom: The power of leverage.
Leverage helps you build wealth even more over the long term. For example, if you own the investment property for 10 years and it appreciates by five percent each of those years, your $100,000 investment will be worth $814,447. Subtract the $500,000 purchase price to determine that your net worth increased from $100,000 to $314,447.
A $100,000 house bought free and clear might also appreciate five percent each year for ten years—but at the end of that decade, your investment is only worth $162,889.
By using real estate leverage, you took your $100,000 and turned it into $314,447. Your net worth increased by $214,447. Without applying leverage in this scenario, though, your net worth increased by only $62,889.
How Do You Calculate Real Estate Leverage?
The loan-to-value ratio, or LTV, is another way to view your leverage. Your LTV ratio is the amount of your mortgage divided by the value of your property. In the above example, your LTV ratio is 80 percent.
What Are the Benefits of Leveraging Real Estate?
- Increased monthly cash flow. You might only have cash-on-hand to buy one real estate investment outright. But through leverage, 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 costs 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?
For example, let's say the value of that $500,000 property goes down five percent 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 five percent drop will decrease it's value by $5,000. Yes, your net worth still decreased—but that’s better than losing $25,000.
Things can get worse if rent payments fall alongside property values. Then your income decreases, too. 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 doesn’t improve.
The above is an example of overleverage, which means you owe more on your loan or loans than your monthly cash flow. For instance, you have two properties with mortgage payments totaling $2,000. If your monthly rental income drops to $1,500, you’re now overleveraged by $500 a month.
And the more properties you leverage, the worse the hit. Leveraging more real estate can multiply your return on investment if home values appreciate—but the inverse is true, too. Your net worth falls if you own one depreciating property, and falls even more if you own three depreciating properties.
How Can You Leverage Real Estate Safely?
One of the key indicators you might be overleveraging yourself is purchase price. Don't overpay for a property that's rapidly appreciated; its value is unlikely to continue growing at double-digits.
Likewise, you want to keep your monthly payment as low as possible. A smaller loan payment puts you in a better position to withstand a downturn. If your rental income drops, for example, a lower payment makes it more likely you’ll be able to pay your lender.
One way to lower your mortgage’s monthly payment is by making a larger down payment. You can also reduce your loan costs by finding a loan with a lower interest rate. Check with many lenders before signing a mortgage to see who can give you the best deal.
Above all else, ensuring you have positive cash flow is the smartest way to safely leverage real estate. You achieve positive cash flow when your rental income is higher than your monthly expenses, which include your mortgage payment and maintenance costs. You’re more likely to withstand a drop or lack of appreciation in your investment property if you’re making money from it.
Real estate leverage is an excellent way for real estate investors to build wealth. There are many benefits to leveraging real estate, but it poses some risks. Minimizing these dangers, though, can help you grow your net worth and your real estate investing business.