Owning an investment property comes with a number of benefits, one of which is financial leverage. This term is widely used in the real estate investing business and beginner property investors should know how to fully take advantage of it.
Leveraging real estate is using borrowed money to finance investment properties. This allows property investors to buy a large asset with little money and increase their potential return on investment. A new real estate investor might not know exactly how leverage works and, thus, ends up making some costly mistakes. To avoid this, keep reading as we give an example of leveraging rental properties and explain the mistakes property investors need to avoid when leveraging real estate.
How Leveraging Real Estate Works
As mentioned, leverage works when a real estate investor buys investment properties with little money using borrowed money. Some examples include a mortgage, a partnership, and owner financing. Let’s take an example of how leveraging real estate investments works if you’re taking a mortgage loan. Typically, mortgage lenders will require you to put down 20% of the rental property’s purchase price and they’ll finance the remaining 80%. Assume that you have saved up $50,000 to put toward a single-family rental property. You have a number of options for how to use this capital:
- Option 1: a $50,000 rental property which you can buy full in cash (no leverage)
- Option 2: a $100,000 property in which you can invest your $50,000 and get a mortgage loan to cover the other $50,000 (50% leverage)
- Option 3: two $100,000 investment properties which you can buy, again by investing your $50,000 and a mortgage loan to cover the rest of the purchase price (75% leverage)
- Option 4: a $250,000 property in which you can put down your $50,000 for a mortgage loan to cover the remaining costs (80% leverage)
Furthermore, assume that property values in your real estate market increase or appreciate 6% a year. So, in 12 months, you’ll achieve the following profits:
- Option 1 is now worth $53,000 ($3,000 profit)
- Option 2 is now worth $106,000 ($6,000 profit)
- Option 3 is now worth $212,000 ($12,000 profit)
- Option 4 is now worth $265,000 ($15,000 profit)
As you can see, the more leverage property investors use, the higher their potential return on investment is thanks to appreciation. Another benefit to leveraging real estate is to diversify your investment portfolio by buying more rental properties. This also allows a real estate investor to reduce the overall risk from vacancy loss, a decline in property value, capital improvements, etc.
Now, to succeed in leveraging real estate and multiply your return on investment, avoid these mistakes:
1) Counting on High Real Estate Appreciation
Real estate rental properties are physical assets that increase in value over time. However, many property investors have fallen into the mistake of thinking that what happened in the past will happen again in the future. Meaning, just because your housing market saw a 6% annual increase in recent years, you can’t be certain that this rate will continue this year or in the following years.
Only expecting high appreciation rate can cause a real estate investor to overpay for a rental property only to experience a loss if it doesn’t happen. The past is no predictor of the future! Thus, it’s much safer to plan out leveraging real estate at a slightly lower appreciation rate and be pleasantly surprised if the return on investment is higher than what you expected.
2) Wasting Good Financing on Bad Investments
Just because you have the ability to buy a rental property with little cash doesn’t mean that any property will be a good investment. For example, if the property is overpriced, appreciation will be minimal or, even worse, non-existent. As a result, property investors need to estimate the current and future value of the property before making a purchase. The best way to do so is through a comparative market analysis and an investment property analysis.
With the help of our investment property calculator, these analyses wouldn’t be too hard to perform. Mashvisor’s analytics allows you to compare and analyze different properties in the same location. It also gives you projections of metrics including the cash on cash return, cap rate, rental income, and more on the property level and neighborhood level. Knowing this data assures that you’re buying and leveraging a good real estate investment property.
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3) Ending Up with Payments That Are Too High
The idea of making money and leveraging real estate from other people’s money might make new property investors think that the more they borrow, the better (less cash invested = higher returns). While this is true, borrowing too much is actually a mistake you need to avoid! This is because the more you borrow, the higher the monthly payments will be.
What if the market softens or your rental property experienced an unexpected vacancy? These situations will affect your monthly rental income on which you depend to cover the mortgage payment. If property investors found themselves unable to keep up with the higher monthly payments, their real estate investment will be in jeopardy! As a result, it’s important to get a payment that you can live with.
Moreover, looking back at our options above, you’ll even notice that an 80% leverage on a $250,000 property (option 4) actually yields higher profits than a 50% leverage on a $100,000 property (option 2). Thus, you need to find the right balance between your down payment and the purchase price to succeed in leveraging real estate rental properties.
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4) Neglecting Positive Cash Flow
Cash flow is king and an important factor to successful real estate investing. Even if your goal is to hold the property until it appreciates in value to sell it for a profit, you should never forget about cash flow! The reason for this is fairly simple – if your rental income minus the rental expenses leave you with positive cash flow, you can rest assured that your monthly payments will be covered and that you’ll gain profits even if the property didn’t gain value this year. However, if you end up with negative cash flow, then you’re in hot waters. Positive cash flow properties give you better advantages of leveraging real estate.
Final Thoughts on Leveraging Real Estate
Successful property investors multiply their return on investment through leverage. Even though it’s an attractive benefit of investing in the housing market, it could be tricky and you might end up with opposite results of what you’d hoped for. So, make sure not to fall into these 4 mistakes when leveraging real estate. Mashvisor works to help any real estate investor find the best investment property and make smarter investment decisions. To learn more about our product and the tools we provide for property investors, click here.
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