Risks to Avoid When Using Leverage in Real Estate
What is leverage in real estate? Leverage is using debt to increase the potential return on investment. The most straightforward 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. A 20% down payment means you're using 80% leverage, and 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 or some of the money, or the sellers may be willing to finance some of the purchase price of the property they are selling. All of these are examples of leverage in real estate
An Example of Using Leverage
Let's say that you've been looking for a house in a great neighborhood. You have $50,000 to put toward a house. You find two properties: a $250,000 house for which you will need a mortgage, and a $50,000 house that you could buy outright.
You could move ahead with the $250,000 house, and the bank will give you a $200,000 mortgage if you put down $50,000, or 20%. Assuming that real estate in this area goes up perhaps 5% a year, in 12 months the investment is worth $262,500.
Alternatively, you could also buy the $50,000 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 $52,500.
In the first scenario, 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, you would have lost $12,500. The second scenario would have seen a decline of only $2,500.
Things to Avoid in Using Real Estate Leverage
When appropriately used, 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 real estate investors have gotten into trouble by thinking that what happened before is going to happen again. Perhaps the past few years have been very good in the real estate market. 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 several 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.
When you plan out your leveraged real estate investments, look 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 low 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 vacancies 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, non-existent. If the market retraces itself for a while, you're in serious trouble. Your overpriced property will be a significant drag, and you won't 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. 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.