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Using Leverage in Real Estate by Avoiding Risks: Building Wealth

leverage in real estateArchimedes made the comment, “Give me a lever long enough and a fulcrum strong enough, and I can move the world.”

“Leverage real estate to buy more properties. Invest in real estate with leverage.” You’ve probably heard the phrase many times. Yet it is difficult to get a clear answer as to what it means. All the while, you’ll be told that learning how to do this requires paying for their book or seminar. We’re going to break the mold and tell you what leverage is before explaining how to leverage real estate to build wealth. Leverage is a method that allows you to control properties with little cash.

What Does Leverage Mean in Real Estate?

Leverage in real estate means buying property with debt instead of paying cash. The classic case would be putting 10% down on ten houses and having ten mortgages for the remaining 90% on each property instead of paying 100% for one house. They call it using other people’s money to buy real estate. However, it can be your money that is leveraged, such as when you borrow money from sources you control to put down the down payment on rental properties.

Using Leverage in Real Estate to Buy More Properties

Below are examples of leverage connected with compounding.  We take a $100,000 property and assume a 6.0% inflation rate.  The return of initial cash is expressed as a percent of the amount borrowed.

Property Value After Amount Borrowed
Nothing 50% 75% 90%
1 Year $106,000 6% 12% 24% 60%
5 Years $133,820 79% 68% 135% 338%
10 Years $179,000 79% 158% 316% 791%

To take advantage of this leverage, you do not have to have a high income or assets.  You just need enough credit and the ability to correctly evaluate risks.

The economist David Baxter sets out a distinct advantage of investment real estate:

“Monopolistic or oligopolistic power does not exist within real property markets. Property ownership and especially home ownership is widely distributed.  So is the demand for ownership.  While much has been made of the concentration of the developable land, and the supposed monopoly profits it entails, new building accounts for less than 3% of the total.”

For real estate, the small investor is on even footing with the larger investors.  Real estate wealth based on capital appreciation is likely to continue because investors are allowed to use and profit from the continuing availability of leverage.

Let’s look at a real estate investment with only a 2.5% rate of inflation compounded yearly.  We will see that it is still a good investment when used with leverage.

Property Value After Amount Borrowed
Nothing 50% 75% 90%
1 Year $102,500 2.5% 5% 10% 25%
5 Years $110,381 10% 21% 42% 104%
10 Years $124,886 25% 50% 100% 249%

Some of North America’s greatest fortunes have been built from real estate.  Properly selected, real estate is one of the safest investments you can make.  It is the single biggest investment for most people.

How to Use Leverage in Real Estate?

The most common method for using leverage in real estate is to tap into financial resources you control to put the down payment down on rental properties. For most of us, this is our primary residence.  Can you use your home equity to buy a rental property? The answer is yes, but indirectly. Your lender will let you cash out your home equity to renovate your existing home, pay down debt, invest in the stock market or use for some other purpose.

Most lenders won’t let you take out a mortgage on the current home to explicitly buy another property. Instead, you take out a mortgage on your current home, put part or all of that money down on rental property, and have a separate mortgage on the rental property for the remaining balance.

Why Aren’t More People Leveraging Real Estate to Build Wealth?

The first hurdle that they face is equity requirements. A general rule is that you can’t cash out more than 80% of the equity in your home. Note that this includes any outstanding loan balance you have on your home. If you have a $200,000 home, must have at least $40,000 of equity in the property. If you have a $100,000 left on the mortgage, the lender will only let you borrow up to $60,000.

That’s $200,000 minus the $40,000 equity requirement minus the $100,000 outstanding mortgage balance. And they’ll factor in the balance of any HELOCs and second balances into this equation, as well. If you don’t have enough equity in your home, leveraging real estate like this isn’t an option.

Build Wealth One House at a Time

If the home is paid off, leveraging real estate to build wealth starts by taking out a mortgage for up to $160,000 on your primary residence. Then that money would be put down on one or more rental properties. If you put $40,000 down on each rental property worth as much as your current home, you would be able to buy up to four homes to rent out. Know that you’d need to pay realtor fees, legal fees and repairs to the properties.

Realistically, you could buy three properties easily. When leveraging real estate, you need to be certain to rent the properties out for enough to pay the mortgage, taxes, insurance and money toward your own mortgage payments as well.

Other Ways of Using Leverage in Real Estate

Leverage real estate can be bought through other means. In theory, you can borrow against your 401K to raise a down payment on a rental property. You’ll have to pay interest on this loan, and if you lose your job, the entire loan is due immediately or else you have to pay taxes and the early withdrawal penalty on the outstanding balance.

If you’re going to leverage real estate using your 401K, we suggest only borrowing enough to make a down payment on a single rental property. Then the loan balance is enough that you could raise the money through other channels if you had to pay it back all at once. The primary mortgage for the rental properties, though, would be secured by the rental properties themselves.

It is in theory possible to leverage real estate using money from credit cards, but this isn’t advisable. You’re paying an insane 10 to 20 percent interest rate on property that will at most yield a 10% ROI. And that’s aside from the risk that comes from being in debt up to your eyeballs.

It is possible to leverage real estate by taking out hard money loans and other expensive, short term loans to raise the money needed to put a down payment on a rental property or fix-and-flip. This is a dangerous method of leveraging real estate to build wealth unless you’re a professional building contractor. In general, the average person shouldn’t be trying to buy fixer-uppers, attempting to manage repairs, and then hope they can sell the property for a profit.

It makes for entertaining reality television shows, but in reality, a lot of the properties don’t sell for enough to be worth the effort. Even professional building contractors have to be careful not to end up “owning their jobs”, earning as much from a series of flipped fixer-uppers as they would from a job.

Inflation Can Help Real Estate Appreciate

The federal government is running on an annual deficit.  The government has no politically acceptable alternatives other than to “print” new currency into existence.  While that happens inflation will creep into the general economy in the form of price inflation.  And one day, maybe in the not too distant future, we may likely see a rapid flare up with hyperinflation.

As long as the dollar’s value continues to go down, people will continue to resort to real estate as a hedge against inflation.  Moreover, this will contribute significantly to the future demand for real estate. Thus creating an increase in real estate property values.

Risks to Avoid When Using Leverage in Real Estate

What is the downside of using leverage in real estate? Leveraging real estate to build wealth sounds perfect, but it comes with risks. And it is the risks of leveraging real estate that cause the horror stories that scare many from trying. What are the risks you need to avoid when leveraging real estate? And what can you do to minimize the damage when these things happen?

The greatest risk of leveraging real estate is that you may end up losing everything, including your own home, if you make a mistake. The best risk mitigation technique is to make sure you can pay your own mortgage if the renters fail to pay. It may be stressful to pay your primary mortgage and the mortgage you took out to buy investment properties. However, if you can pay that bill even if the property is empty or the renters aren’t paying, you won’t lose your home.

You can minimize the financial stress when leveraging real estate to build wealth by being financially conservative. Don’t borrow as much as you can afford to borrow, and snap up as many properties as possible. Buy one or two properties that are well within your budget, being careful not to overpay on the properties or buy houses that need massive work.

Give yourself plenty of margin when estimating property taxes, insurance and other carrying costs. Don’t make financial decisions assuming a best case scenario, such as thinking you can sell the house for 50% more or rent it out for $2000 a month when the average rent for the area is $1500.

It is said that you make the money on the buy, especially for fix-and-flip but also in property you’ll hold onto for the long term. However, this doesn’t mean you should buy any cheap “deal” that comes along. Do your due diligence. Have every property thoroughly inspected, so that you don’t pay $100,000 for property that needs $30,000 more in repairs than you thought it did. If it needs specific repairs to be habitable, ensure that the property is sufficiently discounted.

You’ll lose money if you overpay on repairs and upgrades to a property. Get multiple estimates on the cost and scope of repairs, because overpaying for repairs and upgrades is a waste of money you cannot recoup. Get the properties up to neighborhood standards while skipping the temptation to add granite countertops and make the rental look like a model home.

No one will pay a premium to live in a fancy house in a working class neighborhood. What happens if you end up with a basic rental property? You have tenants who will pay the going rate, and you can plan on upgrading the property after they move out.

A common mistake when leveraging real estate to build wealth is focusing on the house and not the cash flow. The goal of rental real estate is to get paying renters into the property as quickly as possible. Then start collecting rent. You cannot take the risk of getting bad tenants who don’t pay the rent or may even trash the place. Vet tenants based on their ability to pay the rent and their payment history in the past.

If they have criminal histories or tons of drama, don’t rent to them. You can’t afford to evict them later, much less after they’ve failed to pay rent for four months. Don’t forget to comparison shop for property insurance, property managers and anything else you’ll have to pay on a regular basis. These costs will only multiply as you add to your real estate portfolio.

Another mistake in leveraging real estate is rushing to go buy the next property. Take your time paying down the mortgage on the rental properties and your own mortgage. Build the equity back up in all of the properties. This will make you look better to potential lenders in the future instead of literally mortgaging yourself to the hilt. You’ll be certain not to lose money if you have to sell a property for any reason.

You can reduce the risk when you leverage real estate by having a large emergency fund. We’re talking about tens of thousands of dollars of cash set aside, not a line of credit. This money allows you to pay for the surprise bill to replace a dead air conditioner at the rental house without taking out another home equity loan, or worse, charging it on a credit card.

Don’t make the mistake of assuming appreciation will save you when it comes to real estate investing. Never go into the financial hole on the mere hope the property will be worth 10% next year.

Should You Use Leverage in Real Estate? The Conclusion

It is possible to earn significant profits or steady cash flow when you leverage real estate. However, there is risk involved with such projects beyond going into debt. Take care with every decision along the way and walk away from deals that don’t have enough margin, because you don’t want to go bankrupt or lose everything in what seemed like a way to get rich quick with other people’s money. That said, leveraging real estate to build wealth is a legitimate way of generating steady cash flow if you’re conservative on everything from financial projections to your debt load.


References:

Mistakes people make
https://www.thebalancesmb.com/top-don-ts-in-using-real-estate-leverage-2867098
https://www.mashvisor.com/blog/real-estate-investments-leverage                              https://www.homeunion.com/3-risks-of-real-estate-investing-and-how-to-minimize-them

How leveraging works
https://www.investopedia.com/articles/mortgages-real-estate/10/increase-your-real-estate-net-worth.asp
https://www.biggerpockets.com/blog/2016/07/30/completepower-leveraging

What is leverage                                                                                                              https://finance.zacks.com/much-equity-can-borrow-8696.html                                https://www.homeunion.com/how-financing-a-rental-property-gives-you-leverage-in-real-estate-investments

Types of real estate investing
https://www.daveramsey.com/blog/how-to-invest-in-real-estate


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