Risks to Avoid When Using Leverage in Real Estate
Leverage is the use of various financial instruments or borrowed capital to purchase and/or increase the potential return of investment—the term is used on both Wall Street and in the Main Street real estate market.
The easiest example for real estate is a mortgage, where you're using your own money to leverage the purchase. In most cases, a 20% down payment (and a good credit history) gets you 100% of the property and house you want. Some mortgage programs may even let you put down less.
If you're a real estate investor, you may be operating within a partnership and the partners may be putting up all of some of the money, or the sellers may be willing to finance some of the purchase price of the property they are selling. All are examples of leverage
An Example of Leverage
Let's say that you've been looking for a house in a great neighborhood. You find two properties: a $500,000 house for which you will need a mortgage, and a $100,000 house that you could buy outright.
Scenario 1: You move ahead with the $500,000 house, and the bank will give you a $400,000 mortgage if you put down $100,000, or 20%. Assuming that real estate in this area goes up perhaps 5% a year, in 12 months the investment is worth $525,000.
Scenario 2: You buy the $100,000 house outright there's no mortgage and you don't owe anybody anything. If the real estate market goes up 5% a year, in 12 months your investment is worth $105,000.
In Scenario 1, leverage worked in your favor, increasing the value of your real estate investment. But, if real estate prices fell by 5% in that first year, scenario 1 would have lost $25,000. Scenario 2 would have seen a decline of only $5,000.
Things to Avoid in Using Real Estate Leverage
Used properly, real estate leverage can be an effective tool for real estate investors to increase their return on investment. The key is to avoid making decisions without proper consideration of the areas of risk in leverage. Avoid these high-risk behaviors and you have a far better chance of realizing success in using real estate leverage.
Counting on High Levels of Appreciation
Many a real estate investor has gotten into trouble by thinking what happened before is going to happen again. Perhaps the past few years have been very good in real estate marketing. History, however, is no predictor of the future - you can't rely on the future to produce the same results.
Even if the property has been appreciating at a 12% to 20% rate for a number of years, counting on that rate to continue is an extremely risky proposition. It can cause you to overpay for properties, expecting to realize the difference at the sale from appreciation. If it doesn't happen, you're holding a loss or worse.
When you plan out your leveraged real estate investments look, at least, at three scenarios: best; worst; and most likely.
Ending Up With Too High a Payment
It can seem like a great investment to control property with a very small down payment. You're looking at the numbers and seeing a really high return on investment due to your low cash outlay.
The problem is the higher payments that come with higher leverage. If this is a mortgage, for instance, you can count on having to make monthly payments, and the more you borrowed, the higher the monthly payment.
Should the market soften or your properties experience higher-than-expected vacancy or credit losses, you could find yourself unable to maintain those higher mortgage payments that seemed fine at the beginning. If you are unable to make the monthlies, your investment is in jeopardy.
Letting Good Financing Result in a Bad Purchase
Many an investor has overpaid for a property because they found nirvana in a high leverage financing setup. Said differently, just because you can get a property with very little cash outlay doesn't mean that it's a good buy. Look at the value of the property in the context of current and expected market trends. Find "comparables" or other properties like it. What have they sold for? What is selling in the area?
If the property is overpriced, appreciation will be minimal or worse, be non-existent. And woe is unto you if the market retraces itself for a while. Your overpriced property will be a significant drag and you'll not be able to unload it without taking a loss.
Forgetting That Cash Flow Is King
If just one of these "don't" behaviors sticks in your mind, this is the one that you should consider carefully. Errors in judgment in one or more of the other items here can be overlooked if you have that one great thing—excellent cash flow.
If your rental income, minus your mortgage costs and expenses, is putting a nice cash return in your pocket every month, then the fact that the property didn't gain in value this year won't be as worrisome of an event. But if all your real estate investments are down, you're in a lot of hot water.