Leverage is a tool that real estate investors use to increase potential returns from rental property. While using leverage may help improve returns, being over leveraged can be too much of a good thing.
In this article, we’ll take a look at how real estate leverage works, and explain how investors use leverage to boost potential returns, to help answer the question if being over leveraged is good or bad.
Key takeaways
- Leverage in real estate is a tool investors use to purchase a rental property by using other people’s money.
- An investor may be over leveraged when there is too much debt compared to equity in a property.
- Investors who are willing to accept high levels of risk may use more leverage in their portfolio in the hope of increasing potential returns.
- An over leveraged investor may quickly see financial stress if rental income is lower than expected or property prices decline.
What is real estate leverage?
Real estate leverage is a technique that investors use to acquire a property using a combination of debt and equity. When a property is over leveraged, the loan-to-value (LTV) ratio is high because a borrower makes the smallest down payment possible, or sometimes no down payment at all.
For example, assume an investor manages to buy a rental property with no down payment and finances the entire purchase price. The investor’s leverage would be 100%, a situation which could be described as being over leveraged.
On the other hand, an investor who pays all cash for a property could be described as being under leveraged – or more appropriately, un-leveraged – because the asset is being purchased without the use of debt.
Things to know about real estate leverage
One of the best things about investing in real estate is that leverage makes it possible to generate potential profits through the rental income and property appreciation of a rental property by using other people’s money.
Although it may seem implausible, investors who use high amounts of leverage may be able to increase returns by using very little money of their own.
To illustrate how leverage may increase returns, we’ll look at one of the most commonly used metrics – the cash-on-cash return. Cash-on-cash return compares the amount of pre-tax cash received to the total amount of cash invested.
Putting money into an interest-bearing savings account is a simple example of cash-on-cash return. If the local bank or savings and loan offers an annual interest rate of 0.5% for a deposit of $100,000, a depositor would earn a cash-on-cash return of $500 or one half of one percent:
- Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
- $500 annual pre-tax cash flow / $100,000 total cash invested = 0.5% cash-on-cash return
Cash-on-cash return in real estate works in a similar way. Here’s how the cash-on-cash return would vary when an investor is over leveraged, uses conservative leverage, or no leverage at all.
Over leveraged
Let’s assume an investor purchases a $100,000 rental property for a down payment of 5% ($5,000) and finances the rest. If the gross annual rental income is $12,000, operating expenses are $4,800 and the annual mortgage payment (principal and interest) is $5,450, the annual pre-tax cash flow is $1,750.
By dividing the pre-tax cash flow of $1,750 by the total cash invested of $5,000, the cash-on-cash return would be 35%:
- $1,750 annual pre-tax cash flow / $5,000 total cash invested = 35%
While an annual return of 35% may be very impressive on paper, there is a high level of risk involved when an investor is over leveraged.
By dividing the pre-tax cash flow by 12 months, we can see that the investor generates a positive cash flow of only $145.83 per month. That small amount of cash doesn’t leave a lot of room for error if something goes wrong.
For example, the total expenses for operating and financing the rental property in this example are $10,250 per year or $854.17 per month. If the current tenant leaves and it takes longer than expected to find another qualified tenant, or if costly repair needs to be made, cash flow on an over leveraged property could turn negative in the blink of an eye.
Conservative leverage
Most lenders making loans on a rental property require a minimum down payment of at least 25% of the purchase price, and sometimes more depending on factors such as the borrower’s credit score and type of rental property being financed.
By making a larger down payment of 25% or $25,000 on the same $100,000 rental property, an investor earns a lower cash-on-cash return. However, there is also more monthly cash flow because the mortgage payment is reduced.
If the operating expenses are $4,800 per year and the annual mortgage payment (principal and interest) is reduced to $4,300, the annual pre-tax cash flow would be $2,900 and the cash-on-cash return would be 11.6%:
- $2,900 annual pre-tax cash flow / $25,000 total cash invested = 11.6%
While the cash-on-cash return isn’t nearly as great as when an investor is over leveraged, there’s more margin for error in case something goes wrong.
No leverage
Some real estate investors out there don’t like the idea of paying interest, even though mortgage interest is a tax deductible expense of owning a rental property. Instead, they purchase a property with 100% cash and no leverage.
Although the cash-on-cash return is much lower, investors who are risk averse may sleep better at night knowing that they don’t owe the bank anything.
Using the same $100,000 rental property, the annual pre-tax cash flow of $7,200 is calculated by subtracting the annual operating expenses of $4,800 from the annual gross rental income of $12,000.
By dividing the annual pre-tax cash flow by the $100,000 used to pay for the rental property in cash, the cash-on-cash return would be 7.2%:
- $7,200 annual pre-tax cash flow / $100,000 total cash invested = 7.2%
In this example, there’s quite a bit of cash flow each month if the tenant unexpectedly leaves or a major repair needs to be done.
In fact, some real estate investors try to reduce the leverage or outstanding debt on one property as quickly as possible. Then, they set aside the cash flow until enough money has been saved to make the down payment on another rental property.
How real estate financing works
A real estate investor has to have access to other people’s money in order to leverage real estate. Methods for obtaining a rental property loan include:
- Traditional banks.
- Credit unions.
- Mortgage brokers.
- Private money and hard money lenders.
- Partnering with other real estate investors by forming a joint venture or a limited liability company (LLC).
Interest rates, loan fees, and terms and conditions vary from lender to lender. Generally speaking, a lender will expect an investor to have a credit score of at least 620, a debt-to-income (DTI) ratio of no more than 36%, and to hold enough cash in reserve to make six months of mortgage payments.
Is it good to be over leveraged?
Leverage in real estate can be a good tool to increase potential returns. However, being over leveraged can put an investor in a perilous position if real estate market conditions change or the property doesn’t cash flow as expected.
During the Global Financial Crisis of 2007 – 2009, millions of people defaulted on their loans and lost them to foreclosure. Over that 2-year period, the median sales price of houses sold in the U.S. dropped by nearly 20%, according to the Federal Reserve.
An over leveraged investor could easily have been turned upside down, with the mortgage debt on the property greater than the property market value. On the other hand, an investor using conservative leverage may still have had some equity in the property, making it easier to sit tight and wait for housing prices to recover.
Of course, not using any leverage may also mean leaving money on the table, especially when interest rates are low.
In our examples above, an investor using a conservative amount of leverage generated a cash-on-cash return of 11.6% by making a down payment of 25%. While that return isn’t nearly as great as being over leveraged, using less leverage can help create a more balanced blend of risk and potential reward.
Final thoughts
Investors who are willing to accept high levels of risk may choose to over leverage a property purchase by making as small of a down payment as possible to increase potential returns. But while the returns may be impressive on paper, there’s much less margin for error in case something goes wrong.
Leverage in real estate can be a powerful tool to increase potential returns, but investors may wish to think about the risks involved and not just the rewards. An investor who is over leveraged may quickly have cash flow problems if the real estate market changes, while investors who use leverage wisely may be better prepared for the unexpected.
