What’s better than putting your money to work for you? Putting someone else’s money to work for you.
In investing terms, this is called leverage: capital borrowed to increase the return on some investment (ROI). Leverage is simply the percentage of your investment paid by someone else — so the higher the leverage, the more valuable the investment you can make. In other words: as your leverage increases, so does your potential gain.
The most common form of leverage in real estate is something you’re probably already familiar with: a mortgage. To get a mortgage, a buyer puts money down on a home (say, 20%), and borrows the rest (80%) by promising to pay it back — with interest! — over the next 10 to 30 years. This borrowed 80% of the investment is leverage.
The key here is that for just 20% of a home’s cost, a shrewd buyer can own 100% of its value. And though the buyer is on the hook for mortgage payments, any income generated or appreciation realized on their new home is fully theirs to keep.
The Power of Leverage in Real Estate
Leverage is the reason that people without hundreds of thousands of dollars can afford to buy homes for their families. It’s also the reason that anyone can become a property investor. If you can access leverage, you can purchase properties and use them to make a profit.
And it’s worth repeating that the higher your leverage, the greater your potential ROI. Having to put 10% down for your mortgage instead of 20% means that in theory, you can afford to purchase a home worth twice as much. In theory, again, your return on this investment will be higher than your return on the less valuable property.
By leveraging your ability to make higher-ROI investments, you can grow your net worth without being restricted by a lack of personal capital.
The benefits of leverage can compound. As a real estate investor, you might use high leverage to purchase two rental properties that diversify your portfolio and minimize the risk of vacancy, damage, or defaulting tenants. Then, using the income generated by these properties, you might access enough leverage to purchase a multi-family rental unit that will generate even more income — and so on.
What Are the Risks of Accessing Leverage?
You may have noticed the catch already: the ability to access leverage means you can make more valuable investments, but it in no way guarantees that those investments will pay off.
In the context of real estate, high leverage is good when home prices and rental rates are going up. When these metrics are stagnant, the value of your investment may not outweigh the cost of obtaining the leverage to make it (the interest on your mortgage payments). And if home prices fall, it’s possible for you to owe more on a property than it’s worth.
This is, of course, the risk with any investment: if ROI is negative, you lose money. And the power of leverage, if used unwisely, can compound these losses — just as leverage used prudently compounds profits.
Minimizing this risk while maximizing leverage is the goal of savvy real estate investors everywhere. There are some simple, commonsense principles you can apply to achieve this yourself.
Firstly, be as conservative as possible in your estimates of a property’s appreciation; this will reduce the impact of any unforeseen market downturn. Secondly, recognize that you must be able to maintain the costs of any property, regardless of leverage. It will do you no good to buy a high-value property you can’t afford to keep. And finally, remember the catch of leverage: just because you can get it, doesn’t mean you should. Always judge the value of a real estate investment on its own merits first.
If you’re considering purchasing an investment property, you should connect with an experienced Clever Partner Agent who specializes in real estate investing. A local real estate agent will understand your market better than anyone else, and this understanding is critical if you want to take advantage of leverage and make a successful investment.