Real Estate Leverage – the Top 4 Don’ts

real estate leverage

Real Estate leverage is the use of borrowed money to increase your profits in an investment.  Building wealth via real estate requires the use of leverage.

Let’s assume you have $100,000 to invest and you purchase a small income property for $100,000.  Let’s assume that income properties have been appreciating at an average of 7% per year.  At the end of the first year of operation,  your property is worth $107,000.  At the end of year two, it is worth $114,490.  Now let’s assume that you put your $100,000 down on a $500,000 income property.  At the end of the first year, it is worth $535,000.  At the end of the second year, it is worth $572,450.  By using leverage or borrowed money to purchase a larger income property, you have increased your profit by $57,960 in just two years.

To get the full advantage of leverage, put the minimum down on a good property which has a strong likelihood of appreciating in value.  Stay away from questionable properties in run down areas.When you purchase a piece of real estate, you make use of leverage when you borrow money towards the purchase price.

Avoid these high risk behaviors and you have a far better chance of realizing success in using real estate leverage.

1. Don’t Count on High Levels of Appreciation
Many a real estate investor has gotten into financial trouble by looking at past history, even if recent, and relying on the future to produce the same results.Even if property has been appreciating at a 12% to 20% rate for a number of years, counting on that rate to continue is an extremely risky proposition. It can cause you to overpay for properties, expecting to realize the difference at sale from appreciation. If it doesn’t happen, you’re holding a loss or worse.

2. Don’t End up With Too High a Payment
It can seem like a great investment to control a property with a very small down payment. You’re looking at the numbers and seeing a really high return on investment due to your low cash outlay.The problem is the higher payments that come with higher leverage. Should the market soften or your properties experience higher-than-expected vacancy or credit losses, you could find yourself unable to maintain those higher mortgage payments that seemed fine at the beginning.

3. Don’t Let Good Financing Result in a Bad Purchase
Many an investor has overpaid for a property because they found nirvana in a high leverage financing setup. Just because you can get a property with very little cash outlay doesn’t mean that it’s a good buy. Look at the value of the property in the context of current and expected market trends.If the property is overpriced, appreciation will be minimal or worse be non-existent. And woe be unto you if the market retraces itself for a while. Your overpriced property will be a significant drag and you’ll not be able to unload it without taking a loss.

4. Don’t Forget That Cash Flow is King
If just one of these “don’t” behaviors sticks in your mind, this is the one that you should consider carefully. Errors in judgement in one or more of the other items here can be overlooked if you have that one great thing – excellent cash flow.If your rental income minus your mortgage costs and expenses is putting a nice cash return in your pocket every month, then the fact that the property didn’t gain in value this year won’t be as worrisome of an event.

Sources: James Kimmons (Taos Real Estate); Advantage Software, LLC

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