Leverage is one of the most powerful tools real estate investors have. By using leverage in real estate, investors can buy bigger properties, scale up a rental property portfolio, and diversify with different property in more markets.
Best of all, leverage lets investors do all of these and more by minimizing the amount of personal capital invested in a deal while reaping all of the rewards.
What is real estate leverage?
Real estate leverage is the use of other people’s money (OPM) to buy property. Those “other people” can be banks, credit unions, friends and family, or joint venture business partners.
The property market isn’t the only asset class where buyers use leverage. Other examples include buying stocks on margin, buying a car on credit, or using a credit card to make a purchase.
Example of how leverage works
Let’s assume an investor has $100,000 cash on hand. The investor can:
- Pay $100,000 cash for one house using 0% leverage
- Buy two houses, each with a down payment of $50,000, using 50% leverage
- Buy five houses, each with a down payment of $20,000, using 20% leverage
Assuming home values increase 3% annually, after one year the investor would:
- Earn a $3,000 gain ($100,000 x 3%) from paying all cash and using 0% leverage
- Earn a $6,000 gain from buying two houses using 50% leverage
- Earn a $15,000 gain from buying five houses using 20% leverage
Why Do Real Estate Investors Use Leverage to Buy Properties?
There are two main reasons why real estate investors use leverage:
- Increase cash-on-cash returns
- Increase equity
- Decrease taxable income
Cash flow and cash-on-cash return
Remember that cash flow = gross rental income – vacancy allowance/operating expenses – mortgage payment.
If a property generates:
- $10,000 gross annual rental income
- <$3,500> vacancy allowance/operating expenses
- <$4,260> mortgage payment
- $2,240 positive cash flow is created
Cash-on-cash return compares the cash flow to the cash invested.
If an investor paid $100,000 for the property using a down payment of $25,000 to earn an annual net cash flow of $2,240 the cash-on-cash return would be:
- Cash flow / Cash invested = Cash-on-cash return
- $2,240 cash flow / $25,000 cash invested = 9% cash-on-cash return
Of course, real estate investors can increase the cash-on-cash return by using more leverage, but there are definite risks that come with overleveraging, as we’ll discuss later in this article.
Real estate investors also use leverage to increase the amount of accrued equity. For example, if the $100,000 property appreciates at 3% per year, at the end of a 5-year holding period an investor would have a total of $40,927 in total equity:
- Year 1 market value: $100,000 + 3% appreciation = $103,000
- Year 2 market value: $103,000 + 3% appreciation = $106,090
- Year 3 market value: $106,090 + 3% appreciation = $109,273
- Year 4 market value: $109,273+ 3% appreciation = $112,551
- Year 5 market value: $112,551 + 3% appreciation = $115,927
After five years the principal balance of the mortgage would also decrease. But, to keep this example simple, we’ll assume it’s still the same:
- Market value after 5-year holding period = $115,927 – current loan balance $75,000 = $40,927
The total cash-on-cash return at the end of the 5-year holding period would be:
- Cash-on-cash return = Cash flow / Cash invested
- $40,927 equity + $11,200 net cash flow ($2,240 x 5 years) = $52,127 / $25,000 cash invested = 208% return
In other words, the investor has more than doubled his money after only five years! Options for putting the increased equity and cash flow to work are:
- Sell the property for a total cash return of $52,127
- Pre-pay the mortgage principal using the annual net cash flow, then refinance the property at the lower loan balance to reduce monthly mortgage payments and increase cash flow
- Refinance the property and pull out the accrued equity to purchase another rental property
Reduce taxable income
Leverage can also be used to reduce the amount of taxable net income with a non-cash depreciation expense.
Most residential rental property is depreciated over 27.5 years at a rate of 3.636% per year, excluding the value of the lot or land. If the most recent real estate property tax assessment values the lot at $10,000 then the total house value to be depreciated is $90,000 ($100,000 purchase price - $10,000 lot value = $90,000):
Annual taxable income before and after depreciation expense:
- $2,240 net cash flow – no depreciation expense = $2,240 as taxable income
- $2,240 net cash flow - $3,267 depreciation expense ($90,000 x 3.636%) = $0 taxable income
So, by using leverage, the investor is able to generate $2,240 in annual net cash flow while paying $0 in taxes on that same income.
How to Leverage One property to Buy More
Five years ago, an investor purchased a $100,000 house with a 25% down payment and financed the rest. Assuming an annual appreciation rate of 3%, at the end of the 5-year hold time the property market value would be $115,927.
Accrued equity in the house is:
- $115,927 market value - $67,614 current mortgage balance = $48,313 available equity
There are two ways the investor can tap into the available equity to buy more rental property:
The amount of equity the investor could access with a HELOC credit is:
- $115,927 market value x 85% = $98,538 - $67,614 current loan balance = $30,924 available as a down payment for one or more real estate investments
A second option the investor has for accessing the available equity is to do a cash-out refinance. Lenders usually require a borrower to keep at least 20% equity in the property, so a cash out refinance would yield:
- $115,927 market value x 80% = $92,741 - $67,614 loan balance to be refinanced = $25,128 from a cash out refinance for additional real estate investing
Doing a cash-out refinance allows an investor to take advantage of a lower interest rate and reduce the monthly mortgage payment. HELOCs, on the other hand, normally carry a higher interest rate since they’re considered a line of credit.
How to Avoid The Risks of Using Leverage
So far, we’ve discussed the benefits of using leverage conservatively. But, as with almost everything else in life, there are downsides to using leverage as well.
Here are some tips for avoiding potential risks of leverage:
Down payment too low, monthly payment too high
Sometimes real estate investors take using leverage to the extreme. To illustrate, let’s look at two examples of buying the same house using a slightly different down payment amount.
The purchase price of the house is $100,000, annual gross rents are $10,000, and operating expenses (including a vacancy allowance of 5% of the gross annual rents) are estimated to be 35% of the gross rental income.
Our investor has the choice of making a 25% down payment or a 10% down payment with a 30-year fixed rate mortgage at 3.92%, and using the $15,000 difference to invest in something else:
- $100,000 – 25% down payment = $75,000 mortgage amount = LTV 75%
- Annual mortgage payment = $4,260 principal and interest
- Annual net cash flow = $10,000 gross rental income - $3,500 operating/vacancy expense - $4,260 annual mortgage payment = $2,240 annual net cash flow or about $187 per month
- $100,000 – 10% down payment = $90,000 mortgage amount = LTV 90%
- Annual mortgage payment = $5,112 principal and interest
- Annual net cash flow = $10,000 gross rental income - $3,500 operating/vacancy expense - $5,112 annual mortgage payment = $1,388 annual net cash flow or about $116 per month
Both scenarios are cash flow positive, and the $70 difference between the two down payment options may not seem like a lot of money. But, one sign of a successful real estate investment is that the property pays for itself through the cash flow generated.
Now let’s say the house sits vacant for two months due to a longer than expected tenant turnover time. The higher vacancy rate would reduce annual cash flow by an additional $1,160 or about $97 per month.
All of a sudden, the 10% down payment scenario is barely cash flow positive ($116 - $97 = $19 per month) while using a down payment of 25% leaves $90 – or nearly 5X the positive cash flow as an extra cushion.
By paying too much attention to leverage and not giving enough attention to cash flow, it’s easy to see how a highly-leveraged property can quickly begin generating negative cash flow.
Believing that property will always appreciate
According to Zillow, for nearly eight years running home values in the U.S. have only gone in one direction – Up. With that kind of positive reinforcement, investors can be forgiven for believing that property prices will always rise.
However, experienced investors know that markets aren’t forgiving, and that real estate moves through normal market cycles, both up and down. Investors who focus mainly on making their profit from potential appreciation run the very real risk of owning a home whose value is upside down, creating negative equity.
For example, let’s assume a market enters a down cycle and median home prices declined 5% annually over a three-year period. The annual decline in value of the $100,000 house purchased with only a 10% down payment and a $90,000 loan would be:
- Year 1: $100,000 – 5% = $95,000 market value
- Year 2: $95,000 – 5% = $90,250 market value
- Year 3: $90,250 – 5% = $85,737 market value
By the end of the second year, the investor has only $250 or his original $10,000 equity remaining, and by the end of the third year the investor has a house with negative equity of nearly $4,300.
On the other hand, using more conservative leverage by making a larger down payment leaves more of a positive equity cushion should markets begin to cycle downward.
Justifying a bad purchase because interest rates are low
More than one investor has succumbed to the temptation of buying a borderline property because interest rates are low, or financing can be highly leveraged. They figure they lower the cash outlay is the better the deal.
Buying an overpriced property likely means there will be little to no appreciation. And, as we’ve just seen, a highly leveraged property that’s also overpriced can quickly lead to negative equity and negative cash flow if the market begins to trend down.
When used prudently, leverage can serve as a powerful tool for scaling up a rental property portfolio. Understanding leverage and how it works allows investors to maximize the return on investment capital:
- Leverage is another term for OPM or other people’s money.
- One reason real estate investors use leverage is to maximize returns by minimizing the amount of cash invested.
- Leverage can increase cash-on-cash returns, boost equity, and reduce taxable net income.
- Risks of using too much leverage include creating a monthly mortgage payment that’s too high and buying a bad property simply because it can be easily financed.