If you seek ways to expand your real estate portfolio this question arises: “How do you use leverage to build wealth?”.
But before going into the details let’s define “leverage”.
What Is Real Estate Leverage?
The Balance Small Business site describes leverage as “using debt to increase the potential return on investment”.
An example of leverage is when you pay a 20% down payment to get 100% of real property. The 80% becomes the leverage. Thus, if you buy a $200,000 rental house with a $40,000 down payment the lender gives you $160,000 for the purchase.
Therefore, real estate leverage allows you to increase the return on investment.
Why do You Need to Leverage to Build Wealth?
Two main reasons exist for why you would need to borrow money to buy property investments:
- You don’t have the cash to buy the investment property; or
- You wish to maximize your return using less cash for each investment.
Leveraging increases your return when the interest you pay is less than the rate on the Return On Investment (ROI).
For instance, if the rate of return is 9% while you pay 5% on the loan, you will earn a 4% difference.
It’s important to evaluate investment with leverage by calculating your cash-on-cash return. A cash-on-cash return equals the net cash you receive from the investment based on cash put in and net cash received after all loan payments and expenses.
Here is a formula to determine cash-on-cash return by subtracting the loan payments from the rental net income to equal cash flow:
Cash Flow = Net Income – Loan Payment
Then, divide the annual cash flow by your down payment:
Cash on Cash Return = Annual Pre-tax Cash Flow ________________________ Total Cash Invested
Learn more about this formula by viewing “Understanding Cash-On-Cash Returns”
Ways to Borrow for Real Estate Investments
Leverage your real estate investments by applying for financing from any of these types of lenders:
- Credit Unions;
- Hard Money Lenders; and
- Private Money Lenders.
The lenders will determine the value of your property, its expected income, and your personal credit before deciding to approve your loan. Then, at what interest rate and terms to offer you. Also, how much they will finance and your down payment.
For example, you apply for a $1 million loan and the lender agrees to finance 75%. This means you get $750,000 against your $250,000 down payment.
Is Real Estate Debt Bad?
When you think about debt, do you feel good about it? Probably not. Visions of owing a lender lots of money and debt collectors may come to mind.
Instead of thinking about a loss, think about the gain!
Properly managing equity properties can compound wealth. Especially in a rising real estate market, access to equity accelerates growth. Thus, putting a little money down to increase your investment makes sense.
How Leveraging Real Estate Builds Wealth
Similar to investing in the stock market to generate a return. Yet, real estate investing has advantages over the stock market. Investing in the stock market requires cash. Invest $100,000 buying stocks means the stocks must increase by $100,000 to double your money.
On the other hand, putting down $20,000 for a $100,000 house means the house only must appreciate by 20% to double your cash investment.
Real estate investments offer greater flexibility than stocks. Buy a “value-add” house and renovate to increase the property’s value. You can’t do that with stocks.
Once you reach the 20% minimum equity gain you can cash out by refinancing or selling the house. If you live in the house for at least two years the gains are tax-free.
Similarly, you can borrow against your house equity with a “HELOC” which acts like a credit card. Use the funds as you wish. Investors use HELOCs to buy more properties.
The Benefits of Real Estate Leveraging to Build Wealth
Besides increasing your Return On Investment (ROI), here are other leveraging benefits:
- Decrease Risk with Diversity – Leveraging allows you to buy more diverse (different classes) rental properties which insulate you from risk;
- Increase Tax Deductions – You can get mortgage payment deductions along with rental property improvements expenses tax deductions. Increase your rental investments for more deductions; and
- Increase Your Monthly Cash Flow – Leveraging lets you buy more properties to generate more rental income.
How Equity Builds
Building your equity is a huge advantage with leveraging. When you complete your first purchase the cash you put up (down payment) becomes your equity. Over time, each monthly payment brings down the principal on your loan. Thus, you build equity that your tenants pay for.
Leveraging Saves Taxes
Leveraging allows you to “depreciate” the total cost of your investment (not just the cash you put into it). This gives you a large tax deduction every year.
In addition, you can write off the interest you pay on your loan. This gives you another annual tax deduction.
Avoid These Risks Using Leverage
Every investment carries risks. But, you can lower the risks when leveraging your real estate investments. Avoid these high-risk behaviors to realize success when you use leveraging:
Relying on High Appreciation
Too many real estate investors count on expected high levels of appreciation. This causes you to overpay on your houses expecting to realize big gains when you sell. Often based on market history, yet history is a bad indicator of future success.
Back in 2008, when the U.S. real estate market tanked many investors lost their shirts and their properties. Don’t let this happen to you.
Buying a property with a low down payment while focusing on the gain when selling leads to high risks.
Making Too High Payments
A low-down payment means higher leverage. The more you borrow results in your monthly payments becoming higher.
If the market softens or you experience more vacancies than you expected your higher mortgage payments put your investments in jeopardy.
Tip: Avoid this mistake by looking at the property’s value currently and expected market trends. Use “Comparable” of similar houses to see what they sold for and the area’s selling data.
Overpriced houses make appreciation non-existent. A down market makes your overpriced house drag you down.
Work with an experienced Realtor who knows the market to help you price investments correctly
Never Forget Cash Flow Is King
The above mistakes won’t bankrupt you if you maintain excellent cash flow.
Maintaining good rental income minus expenses and mortgage costs gives you a nice cash flow every month. Slow appreciation won’t hurt you as long as good cash flows. If not, your investments turn into hot water.
Learn Other Ways How You Use Leverage to Build Wealth
Our WeLease Blog offers many ways for using leverage to build wealth including:
- How to Make Millions with Rental Properties;
- How to Understand CAO and ROI Rates; and
- Why Real Estate Rental Investors Fail.
How Do You Use Leverage To Build Wealth? – Conclusion
This how do you use leverage to build wealth post teaches you about:
- Real estate leverage allows you to increase the return on investment;
- Leverage lets you take advantage of tax benefits like depreciation and interest deductions;
- Leveraging increases your return when the interest you pay is less than the rate on the ROI;
- How to determine cash-on-cash return;
- Buying a “value-add” house and renovating increases the property’s value;
- Borrow against your house equity with a “HELOC”;
- Decrease Risk with diversity;
- Increase tax deductions;
- Increase your monthly cash flow;
- Leveraging lets you build equity;
- Lower Risks by not relying on high appreciation and making too high payments; and
- Never Forget Cash Flow is King.
Looking to Buy Rental Houses in San Diego?
WeLease not only provides superior property management services we can help you with finding profitable houses to buy and rent in San Diego County.
Contact us to learn about our professional property management services to increase your ROI.
Steven Rich, MBA – Guest Blogger
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