Leverage is the use of financing to borrow capital for an investment, with the expectation that multiplying the risk-reward relationship of the investment will create more potential profit. In other words, the more money you invest, the more risk you have and the larger the reward (profits) you receive, if all goes as well with your investment.
The difference between paying cash and financing
Let us assume you have $100,000 to invest and want to purchase a rental property. You find a rental property for $100,000 and you decide to finance that property with a 20% down payment at 5% interest. If that property rents for $1,000 per month, it is making a 12% gross annual return. After you deduct the mortgage interest you are making a net of 7%. That’s a pretty good return and you didn't have to spend the full $100,000 to get it either. You only spent $20,000 out of pocket for the down payment. Thus leaving you with $80,000 cash left to invest in other properties. Assuming you could repeat the example above you could purchase 5 properties using financing and your $100,000 cash. Giving you a gross income of $60,000 per year and a net income of $35,000 after mortgage interest.
If you pay cash to buy one property you’ll have to spend all of your $100,000 and you’ll make 5% more profit per year because you don’t have a mortgage. Now here is where the leverage kicks in, on the cash deal you have a $12,000 per year rental income, which is a 12% return vs. 7% per house in the 5 house deal. But financing 5 houses using the $100,000 as a down payment (5 x $20k) gives you a $35,000 per year rental income or 35% return. So using leverage in the scenario gives you almost 300% more income!
Mortgages are usually some of the cheapest money you can borrow because the loans are backed by the asset of real estate. Mortgage rates are currently at historically low rates. If you choose to finance, I would only finance properties with a fixed-rate mortgage. The advantage of financing real estate with a fixed-rate mortgage is the rate is locked in and cannot be raised for the term of the mortgage. Another great advantage is you also have the ability to refinance if the interest rates go down or keep the lower rate if rates increase. So they are win-win. Variable-rate and interest-only mortgages might be available at slightly cheaper rates, but the risk of the rate increasing as the loan matures is much higher. For that reason, I would avoid these types of mortgages.
Appreciation is a great wealth builder and the more properties you own, the more wealth you can create. In the previous example, if the real estate market appreciated at 2% per year in five years your portfolio would increase 10% in value. So if you paid cash for the 1 property, your appreciation would be $10,000. If you financed the 5 properties, you would have an increase of $50,000 dollars. This shows how leverage can quickly build and multiply your wealth.
Here is an oversimplified example of how leverage can be used to buy rental properties. This example only uses the 5% interest rate of the financing and a simple $100 per month for expenses. It does not factor in everything, such as taxes, insurance, vacancies, repairs, and maintenance.
|Finance (1 Deal)||Cash (1 Deal)||5 Finance Deals|
|Purchase Amount||$100,000||$100,000||$500,000 ($100k x 5)|
|Down Payment||$20,000||$100,000||$100,000 ($20k x 5)|
|Cash on Cash||10.3%||8.4%||10.3%|
|End of First Year|
Cash flow is king! If you look at the chart comparing cash vs financing, you see that you will have more cash flow with a cash deal vs 1 financed property, but multiply that to 5 properties your cash flow surpasses the single cash deal. If the real estate market is on the rise, then financing offers more potential for wealth building with the benefits of appreciation, mortgage tax deductions, and depreciation. On the other hand, if the real estate market is uncertain or peaking, then I would definitely caution against becoming heavily leveraged in real estate.
Benefits of Using Leverage
- You can use the rental income to pay the mortgage payment
- The property will most likely appreciate over time
- You are building equity in the property every month
- Quicker wealth building with the same amount of starting cash
Negative points to using leverage
- Leverage works well in a bull market where appreciation is on the upswing. If the market is on a flat or downward trend the property could lose value and it could put you in a negative equity situation.
- If you become over-leveraged you could lose money or your property!
- It drains your cash flow.
Leverage is a great tool. I used it frequently when I first started investing in real estate. These days, I do not rely heavily on leverage. I personally do not like to carry to debt, so I use it sparingly. There are still times when it makes sense for me to use financing and I will definitely use it when it is to my advantage. I recently closed on a deal where the owner financed the property at zero interest for 18 months. In that instance, it didn’t cost me anything! So, I took advantage of that opportunity to hang on to my cash. Now I can use my cash to invest in the property renovation and improvements.