WHAT IS LEVERAGE IN REAL ESTATE, AND HOW DO I USE IT?
Defined, “leverage” is the “borrowed capital for (an investment), expecting the profits made to be greater than the interest payable”. So, what is leverage in real estate? Essentially, leverage in real estate is the loan used to buy property, and the amount of potential profit earned during ownership. The amount of leverage you have in real estate depends on several factors: how much cash you’ve invested in the property (think down payment or repair costs), the amount of the loan and interest rate, and the appreciation in property value (the more appreciation, the more your investment is worth and the more profit you will gain from selling it).
In other words, someone that invests a small amount of money in a property and has more liquid assets to invest in something else generally has more leverage than someone who invests a large amount of money and cannot invest in anything else (their entire investment would be in one place, in this case, the property they purchased). Additionally, if both people have equal amounts of liquid assets available for the purchase of real property, the person with the smaller cash investment would see a greater percentage return on that investment.
As an example, take a piece of real estate that will sell for $100,000. Investor A could pay all cash and investor B could put 20% down (or $20,000) and take out a loan for the remaining 80% (or $80,000). If we assume the house appreciates by 10%, investor A (the all cash buyer) would have made a profit on their initial investment of 10% ($10,000 profit divided by $100,000 initial investment). Conversely, investor B (the buyer who used leverage) would have had a 50% gain on their original investment ($10,000 profit divided by $20,000 initial investment). Additionally, investor A would now have $80,000 less cash to invest than investor B because he has $80,000 more cash tied up in this property.
(Scroll down for risks in using leverage)
Leverage works great in an up market, as in the example above; however, it can be risky in a down market. Taking the same example above, if there were a downturn in the housing market and a 10% decline in the home value, the all cash investor has lost 10% of their initial investment, while the leveraged buyer has lost 50% of their initial investment.
As such, it is wiser and more advantageous to use leverage in the real estate market over a sustained period of time (generally five or more years) because historically, real estate has been shown to increase in value over the long-term. It is much riskier to use leverage over a short-term period of time because the market is much less predictable from year to year, than from decade to decade.
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