As a real estate investor, you need to be well-versed in all strategies available to you while building your investment portfolio. One key element is debt, also known as leverage, and how leverage is used can mean the difference between seeing your equity wiped out during a downturn or maintaining positive cash flows to the other side of a cycle.
What is Leverage in Real Estate?
Leverage refers to using borrowed money, in addition to equity, to capitalize an investment property. Leverage reduces the amount of equity required, but generally speaking it also increases the risk profile.
How Do You Use Leverage?
Leveraging investment property revolves around the idea of using lower cost of debt capital to increase equity returns. Debt comes from a variety of different sources including private lenders, banks, insurance companies, CMBS, and others. It can be short term debt, typically known as bridge financing, or long term debt, which for commercial properties typically runs 10 years.
Examples of Leveraging Funds
To gain a better understanding of how to use leverage in your real estate investments, let’s look at an example.
- Say you invest equity equal to 40% of the $500,000 acquisition cost. The 40% equity investment of $200,000 plus the $300,000 loan covers the acquisition cost. You will make regular interest and principal payments on the debt over the term of the loan, but lowering the equity investment increases returns on that capital.
- Let’s consider one more example of leveraging funds in order to buy multiple properties. Some real estate investors specialize in purchasing distressed properties which have a lower initial asking price. Let’s say for the sake of our hypothetical leverage that you find an abandoned property in a good neighborhood that’s only going to cost $100,000. You have the cash on hand, but also recognize that the house is going to need roughly $125,000 worth of work. Yes, you could pay $100,000 for the property, but depending on the size of your cash reserve, it may leave you cash strapped when you’re trying to pay the $125,000 in renovation costs. Instead of spending a full $100,000, you could be better served by leveraging $50,000 from a private lender. Even if they charged 3% interest on their loan, you could be better served by leveraging half the price of a home and repaying them over the course of the next 60 months, especially since the property’s appreciation will increase your net worth.
It’s important to choose a financing strategy that best suits your own investment goals. Leverage is a great tool, especially if you plan on being invested in a given property for the long-term. While some conventional financial experts teach that debt is always bad, that’s simply not the case, especially in the case of cash flowing properties. Debt can be a useful tool if you know how to make it work for you and use it appropriately.
Streitwise has used modest, conservative leverage throughout its portfolio. While there are benefits to completely funding all equity on the one hand and benefits to funding with heavy leverage on the other, Streitwise’s conservative leverage structure gives flexibility during economic uncertainty while also benefiting investors through increased cash yield.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.