Any person who is seriously considering investing in real estate, must understand one of the most important principles of real estate investing: leverage. Leveraging your investments in real estate means using a small amount of money to maximize your return. This reduces the time that you have to wait to save up a down payment and increases your rate of return. While it does increase the risk of real estate investing, it’s the fastest way to build wealth.
What is Real Estate Leverage Exactly?
For those of you who are just looking into investing in real estate and still learning the in’s and out’s, real estate leverage means putting your money to good use. Instead of buying a property outright and keeping a lot of money invested in your property, leveraging your money would use a minimum down payment in order to have a positive cash flow. While it means that you are making less profit per month (because you are paying a monthly mortgage), it also means that you are not tying up your liquid assets.
For example, let’s say that there is a rental property for sale for $100,000. The profitability is not that important for this illustration so I will ignore this aspect. In buying the home, you have two main options. The first would be to pay for this property with cash, assuming you have that much money laying around. The second would be to get a mortgage, with putting $10,000 down as a down payment.
What’s the Benefit of Leverage?
If you were to buy the property outright, you would make a larger profit each month because the only expense that you would have would be regular maintenance. Having a mortgage would mean higher expenses, but it would also mean that you have $90,000 left to play with. In theory, you could buy and rent multiple houses, as long as you can maintain a low vacancy rate.
That way, instead of owning one house and earning X amount of rent each month, you can own multiple houses. While you may make a fraction of the rent from the 1 paid off property, once the mortgages are paid off (which are paid by the renter), your income is exponentially higher.
Utilizing leverage is often the way that people afford to retire early. If they can start investing soon enough and pay off the mortgages early, the huge increase in income from real estate often pushes people over the top.
What’s the Risk of Leverage?
While there is exponential growth possibilities using real estate leverage, but it comes with a little added risk. With leveraging your money, it increases your monthly expenses. Real estate is known for its unexpected costs. So, if you do not prepare for these, like vacancy or major repairs, by setting money aside, you could be forced to lose a couple of your properties.
It’s important to consider how much risk you can afford to take. If you have a steady day job with a lot of extra income or a hefty emergency fund, odds are that you can afford to take a little risk. If you are dependent on the rental income each and every month to get by, then you should not be buying more and more properties. It’s important to grow your real estate business at the right pace – not too fast and not too slow.