Summary: In this article, we will show you the power of leverage in real estate and how to use it to your advantage. Topics include the definition of leverage, financial leverage, leverage in real estate, the best conditions to use leverage in real estate, leveraging real estate investments with mortgages, and an example of why we love leverage.
We have covered this topic in our “Why Real Estate?” section, but this is a reminder of the power of using financing options, like conventional loans, to help jump start your portfolio building. As long as it’s managed responsibly and you are able to cover your payments.
Kathy F., Co-Founder and Co-CEO of Real Wealth, explains the power of leverage and how to use it in real estate investing.
WHAT IS LEVERAGE?
Leverage is a physics term that refers to the ability to use something to move an object that would otherwise be too heavy.
In Kathy’s book, Retire Rich with Rentals, she uses a car jack as a great example to explain leverage. “There’s no way you could lift a car with your bare hands. By placing a jack in the right spot and using the force of leverage, however, you can easily pick up a car of any size,” she says.
WHAT IS FINANCIAL LEVERAGE?
Financial leverage works the same way. In finance, leverage (sometimes referred to as “gearing” in the United Kingdom and Australia) is a general term for any technique to multiply gains and potential losses. Most often it involves buying an asset using borrowed funds, with the belief that the income from the asset will be more than the cost of borrowing.
When comparing leverage and financial leverage, Fettke explains, “The difference is that your leverage is the use of other people’s money (OPM). You can use someone else’s money to supplement what you have in order to buy a home.”
WHAT IS LEVERAGE IN REAL ESTATE
Leverage uses borrowed capital or debt to increase the potential return on 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.
The Best Conditions for Leverage
Using leverage in real estate investing works the best when property values and rents are going up. If values and rents are slow or declining, the advantages of using leverage can evaporate quickly, with loan payments increasing your carrying cost for the property.
For leveraged investors, there are two important practices to achieve optimal success.
- Perform comprehensive due diligence
- Develop a smart investment strategy
LEVERAGING REAL ESTATE INVESTMENTS WITH MORTGAGES
There are so many different ways to get financing to buy an investment property. The most common form of financing includes conventional fixed-rate or adjustable-rate loans. The difference between fixed-rate and adjustable-rate loans is pretty simple, which I will explain next.
A fixed-rate loan is a loan that has the same rate for the life of the loan. If you choose to borrow from a mortgage company, Kathy suggests a 30-year fixed-rate loan. Her reasoning is because the interest rate never changes regardless of what happens in the market.
For example: if your loan payments are $500 per month today, they will stay $500 per month in 10 years.
As the term of the loan is so long, the payments each month will be less than a shorter-term loan, which helps with cash flow.
“Small loan payments, coupled with a predictable rate and the ability to refinance later, are just a few of the things that make a fixed-rate loan so great,” says Fettke. “The one downside is that fixed-rate loans tend to have a slightly higher interest rate than the alternatives. Since the rate will never change, the lender is going to want to cover any losses they might experience when rates go up.”
Adjustable-Rate Mortgage or Loan
An adjustable rate mortgage (ARM) or loan is where the rate of interest is adjusted periodically to reflect market conditions. The interest on an ARM is directly tied to a specific index. Generally speaking, ARMs tend to go up. While there is a possibility your interest rate may go down, this typically happens as a result of a real estate market dip.
The good news is, initial interest rates are usually lower on an ARM than a fixed-rate loan. If you are not able to get a fixed-rate loan for less than 8.5 percent, an adjustable-rate loan may be a good option, suggests Fettke. After a few years, you may be able to refinance your loan and get a better interest rate on a fixed-rate mortgage.
ARMs are also a great choice if you plan to sell your property within the timeframe of the loan, typically 2, 3 and 5 year terms respectively.
WHY WE LOVE LEVERAGE
Next, we will show you exactly why we love leverage in real estate using the following example:
- Joe uses $100,000 to buy gold = $100,000 value.
- Mary uses $100,000 to buy stocks on margin = $200,000 value.
- Pat uses $100,000 as 20% down payment to buy property = $500,000 value.
15 Years Later…
Let’s assume a 5 percent annual growth. Keep in mind, this is a huge assumption as it could be 10 percent annual growth one year or 0 percent the next. However, for the purpose of our example, we will assume 5 percent annual growth:
- Joe’s gold is worth $207,000 = $107,000 profit.
- Mary’s stock is worth $415,000. After paying back the $100k margin and $100k capital = $215,000 profit.
- Pat’s property is worth $1M, $400k loan paid down to $200k = $700,000 profit.
Pat Gets More Bonuses…
- The properties were rented, producing income after expenses = cash flow.
- 10% of $100,000 is an additional $150,000 in 15 years.
- If Pat put all of that cash flow toward paying off the loan, the entire property would be paid off in 15 years.
- $1M equity, plus $120,000 rental income for life.
- Plus tax deductions.
As illustrated by our example, Pat is the clear winner when it comes to return on investment by leveraging real estate to build wealth.
Understanding the power of leverage and how to use it in real estate isn’t just for seasoned investors. Taking advantage of leveraging real estate through financing a property can be a sound investment strategy. Holding onto your leveraged property long-term may not only produce excellent returns, but monthly cash flow as well.