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Multifamily financing for real estate investments is one of the biggest hurdles for investors. As a result, using leverage in real estate is one of the most useful strategies. However, it’s made complex by the unfamiliar word “leverage” and a less than straightforward process.
In this guide, we’ll define what leveraging real estate means and give you a quick real estate leverage calculation. Next, we’ll cover the various types of real estate leverage. Finally, we’ll provide you with a few tips on the risks of leverage.
This post covers:
- What is leverage in real estate?
- What are the types of leverage in real estate?
- Benefits of leverage in real estate
- Tips on risk management when leveraging real estate
What is leverage in real estate?
If you’re looking for a simple definition of leverage in real estate, it’s this:
Leveraging real estate involves borrowing money from the equity of one of your previously owned properties without selling said property. This amount, which often doesn’t include the total percentage of equity, is then used to buy another investment property.
A great leverage in real estate example is when you purchase a commercial property for a $300,000 mortgage.
Thanks to repairs and quality-of-life improvements in your neighborhood, your home value shoots up to $400,000. Leverage comes in when you make a deal with your lender and use a percentage of your $100,000 in equity as payment for your next investment property.
Remember, it’s only considered leverage when you don’t sell your initial investment property to pocket the equity as profit.
What are the types of leverage in real estate?
There is only one process of using leverage in real estate, and that is how to leverage one property to buy another.
So, when discussing the types of leverage used in real estate, we’re actually referring to the financial lenders who allow leverage to be possible.
The types of leverage providers are:
- Mortgage lenders. The bread and butter of property financiers, these lenders require a down payment and offer mortgages for a set number of years.
- Business lines of credit. For serious investors, these lenders provide more immediate financing, which is handy if you plan on quickly leveraging properties.
- Hard-money lenders. You have to put between 20% and 35% down for these loans. But the upside is that you get more quickly — and with fewer stipulations — than conventional mortgage lenders.
- Portfolio lenders. They are similar mortgage lenders but have fewer requirements for additional loans as long as your business is steady and has no risks.
- Home equity line of credit. Otherwise known as a HELOC, this lender allows you to use the value of a property that you currently own as credit for additional property development. For example, investors typically use the most reliable property that they own to establish a HELOC.
Benefits of leverage in real estate
There is one primary benefit to leverage in real estate, and that is leveraging real estate to build wealth. Investors gain the ability to continue developing property without having to pay additional down payments out of pocket.
As a result, they only have to worry about paying for operating expenses, taxes, and renovations for the properties they own.
Leverage has additional benefits for real estate investors who purchase properties that yield rental income. Because investors can quickly acquire more rental properties, they profit from rental income and further their ROI.
Learn how to invest in multifamily real estate:
How much leverage is safe in real estate?
Between 70% and 80% of your equity is considered safe leverage. For example, between $70,000 and $80,000 of $100,000 in equity is considered safe to leverage. This is because your property could potentially depreciate and harm your equity.
What is a good leverage ratio in real estate?
Your leverage ratio is your debt-to-equity ratio. No matter how creative your original financing is, you want to ensure that your debt doesn’t outweigh your equity. A good leverage ratio is either a three or higher.
To calculate your leverage ratio in real estate, divide your debt by your equity. For example, if your mortgage is $300,000 and your equity is $100,000, then your ratio is three and can be considered good.
Leverage ratio formula:
Leverage ratio = Debt / Equity
Tips on risk management when leveraging real estate
There are a number of risks associated with using leverage that aren’t often found with your initial property financing. The common denominator in solving the following problems is to do as much research into your investments as possible.
So, study the market. Then, review decades’ worth of changes and real estate cycles. Additionally, consult professional financial advisors at all times (and please note that we are not professional financial advisors).
Risks of leveraging real estate include:
- Using too much of your equity as leverage.
- Not foreseeing all expenses and operating costs with a property.
- Having a bad debt-to-equity ratio.
- Poor cash flow for rental properties.
- A high monthly payment (which is often the result of too little of an initial down payment).
- Depreciation of property values.
Remember, using high leverage in real estate doesn’t always equate to higher risks as long as you have guarantees that the above risks will not occur.
Takeaways
- Leverage in real estate is when you use the equity from one rental property as a credit to purchase and operate another.
- The five types of leverage lenders in real estate are mortgage lenders, portfolio lenders, HELOCs, business lines of credit, and hard-money lenders.
- Leveraging real estate is beneficial because it allows you to acquire more investment properties quickly and reap the awards of each at no further personal cost.
- Risks associated with leveraging real estate include using too much of your equity as leverage, having a bad debt-to-equity ratio, and property depreciation.
