5 Ways To Use Leverage in Real Estate For Growth

Want to buy rental properties but have little cash to pay upfront? Learning real estate leverage can help you out.

Immediately jumping into real estate investing without knowing what you are doing isn’t a great strategy….I learned the hard way.

Before you get to that point, you have to overcome several hurdles. You need patience, a solid understanding of local real estate laws, regulations, principles, and market trends, and a large down payment.

Most importantly, you need to have a solid investment strategy to help you get started. Good thing that real estate leverage can help you achieve that outcome a little bit easier!

TL;DR:

• Leverage in real estate combines other people’s money with your own capital to increase your ROI and cash-on-cash return.
• Leverage can help investors find a sweet spot that balances risk and reward in their investments if used correctly.
• Leverage can also be a double-edged sword and may work against an investor if used too much. Using too much leverage can result in a larger mortgage payment, more unfavorable loan terms, and an increased risk of negative monthly cash flow.

What is Real Estate Leverage

Simply put, leverage is using borrowed money or capital to increase the return on a real estate investment without having to cough up your own money when buying a property.

Leverage allows a real estate investor to purchase a property that’s beyond their current financial limits.

Benefits of Leverage for Real Estate Investors

Now that we have defined what real estate leverage is, you might be curious about its benefits for investors. Below are the key advantages of incorporating leverage into a real estate portfolio:

Grow Your Investment Portfolio

Using real estate leverage can quickly scale your investment portfolio. You don’t have to save up to just buy one property, leveraging can allow you to potentially own multiple properties –as long as you have cash flow for the monthly payments.

Passive Rental Income

Most investors use their leveraged properties for short or long-term rentals. This approach covers the cost of your loans and allows you to take home some of the profits since you can deduct taxes, interest, depreciation, and mortgage payments in this type of investment.

For example: You just bought a property in a tourist town using leverage. Due to your property’s location, you can potentially turn it into Airbnb unit and rent it out. That way, you can use your property to cover your mortgage balance while earning a positive monthly cash flow as a nice bonus.

Inflation Protection

Experienced real estate investors can make inflation work in their favor through leverage. Since property values often appreciate over time, rental income can be adjusted to keep pace with rising costs, leverage can amplify returns by maintaining fixed debt obligations.

However, successful real estate investing requires careful consideration of location, market conditions, property management, and financing terms.

Types of Real Estate Leverage

Investors turn to borrowing from both financial institutions and private lenders because it’s the easiest way to gain leverage. Here are 5 of the most common types of loans investors use:

Traditional Mortgages

Traditional mortgages are loans available through various financial institutions, including banks, credit unions, and online lenders. They offer the advantage of combining house hacking with them to cover your loan balance while generating a substantial monthly income.

For instance, I have a friend in California who is paying off a 3-bedroom house loan at $4k per month while renting out two rooms for $2k each and residing in the third.

However, when expanding your investment portfolio, you may need to consider portfolio loans instead of traditional ones. Traditional lenders have strict approval criteria based on factors like high credit scores, positive credit history, stable employment, reliable income, low loan-to-value (LTV) ratios, and low debt-to-income (DTI) ratios, making it challenging for investors with less-than-perfect credit scores to qualify.

Another drawback is the time it takes to secure traditional mortgages, typically 30-60 days, due to extensive documentation, multiple reviews, and a lengthy underwriting process.

Portfolio Loans

Portfolio loans are mortgage loans that are originated and held by a lender or financial institution in their own investment portfolio, rather than being sold on the secondary mortgage market to government-sponsored entities like Fannie Mae or Freddie Mac.

These loans are often used to finance real estate transactions that do not meet the strict underwriting criteria of conventional mortgages.

Private Loans

If you have a solid network with real estate investors near you or have a relative, close friend, or business partner willing to let you borrow money, you can raise money through private loans instead of applying for a mortgage from a traditional lender.

Private loans typically start by looking for willing lenders such as a close relative or private investment firms. Next, both parties determine the terms of the loan amount, interest rate, repayment schedule, and any collateral requirements by evaluating the borrower’s collateral value and financial history.

Once done, they sign a “note” to avoid misunderstandings and set boundaries. A note is a legal document outlining the terms and conditions that a borrower signs, promising to repay a loan

Now, you must be thinking, “why would a real estate investor borrow money at a higher interest rate from a private lender when you could have a better option by going through a portfolio lender?”

Compared to portfolio lenders, private lenders are not bound by the same regulations as traditional lenders. They may be more willing to tailor loan agreements to meet the specific needs of the borrower — meaning, all of the terms are negotiable depending on the relationship between you and the lender.

Home Equity Loans or Home Equity Line of Credit (HELOC)

A Home Equity Loan (HELOC) is a financing option that uses the equity in your primary home or other rental properties as leverage to buy more properties.

Home equity loans act as a second mortage that issues you a lump-sum to repay over time while HELOC works similarly to a credit card where you can draw funds as needed.

You can potentially use a HELOC to cover the down payment of your next property, buy the property outright, or pay for any  improvement projects or repairs.

However, they come with a major risk. Once you fail to repay the loan, your lender has the right to foreclose your primary property.

Business Credit

Known as a business line of credit, business credit represents the track record of a real estate company or organization. Investors begin to build their credit score the moment they establish a business or apply for a loan.

Good business credit can help you raise some much-needed financing through your company’s name instead of your own. Plus, you can utilize them to apply for a loan from both traditional banks and online lenders.

Similar to HELOCs, investors can use their business credit to finance new real estate investments through cash purchases, pay for home renovation, etc. Their benefits include, but are not limited to the following:

• Business credit can open up new financing options for established real estate investors and reduce their personal risk in financing an investment.
• Using business credit offers flexible repayment terms for a minimum monthly payment
• Instead of checking your consumer credit reports and scores, the lender will generally review your business credit instead.
• Lenders will review your business credit instead of your credit score and history

However, business credit also has some drawbacks. interest rates are generally high and credit limits low. Plus, your credit scores may suffer even if you pay on time.

Additionally, in the event of a breach of terms and conditions with your issuing lender, they have the right to close your account.

Key Considerations

If you plan on adding leverage to your investment strategies, you need to keep a few things in mind to make it fully work to your advantage.

1. Buy Your First Properties Using Less Leverage- If you’re a new investor, don’t use as much leverage as you can, and never overleverage — overleveraging will only work if you fully know your risk tolerance and investment goals.
   Instead, use as little leverage as possible while you are learning the business.
2. Don’t Leverage Without A Down Payment- Leveraging real estate without a down payment is a big NO because it is too risky for both the lender and investor. Instead, offer to shell out a down payment so you don’t overleverage.

How To Calculate Leverage

There are two ways you can use to calculate your leverage in real estate properties: loan-to-cost (LTC) ratio and loan-to-value (LTV) ratio.

Loan-to-cost Ratio

In real estate, “LTC” stands for “Loan-to-Cost” ratio is used to assess the level of financing required for a real estate development project. LTC represents the percentage of a project’s total cost that is financed through a loan or mortgage.

Understanding LTC is essential for determining how much equity an investor or developer needs to contribute to a project and how much debt financing is required.

The LTC ratio is calculated by dividing the loan amount by the total cost of the real estate project. The total cost typically includes expenses such as land acquisition, construction or renovation costs, development fees, permits, and any other related costs.

LTC = Loan Amount / Total Cost

Loan-to-value Ratio

The LTV ratio measures the percentage of a property’s appraised value or its purchase price, whichever is lower that is financed through a mortgage or loan. LTV is essential for directly impacts loan approval, interest rates, and the overall financial health of a real estate transaction.

For example: You want to acquire a residential property valued at $500,000. To finance the purchase and use leverage to amplify your returns, you secure a mortgage loan of $350,000 and front $150,00 as your own capital.

The LTV ratio is calculated by dividing the loan amount by the property’s appraised value:

Wrapping Up: My Experience With Leverage

Real estate leverage can be a powerful tool for investors looking to expand their portfolios and maximize returns, but it must be used cautiously. Understand your risk tolerance, financial capacity, and market dynamics when considering the use of borrowed capital to finance real estate investments.

FAQs

What does it mean to leverage a property?

In real estate investment terms, leverage is using other people’s money to cover a specific amount of the purchase price of an investment property.

What are the disadvantages of leverage in real estate?

While leverage can magnify returns, it also introduces certain risks and disadvantages in a real estate investment portfolio. Here are some key disadvantages of using leverage in real estate:

• While leverage amplifies the positve impact of real estate market fluctuations, it can also magnify an investor’s losses.
• Real estate loans comes with interest costs, and leveraging increases the overall cost of financing them . If interest rates rise, the cost of servicing debt also increases, impacting your property’s net cash flow.
• Real estate values are dependent on market conditions. If the market does not perform as expected, your property values may fall below the outstanding mortgage balance, resulting in negative equity if investors are forced to sell the property at a loss.