If you have dreams of being a real estate mogul one day, it’s important to know how real estate leverage works. In an ideal scenario, using leveraged real estate can help you grow your property portfolio faster and earn more money from rentals. However, real estate leverage is also not without its risks, so you have to approach it carefully.
So, let’s dig into what it means to leverage real estate, the different types of real estate leverage, and the benefits and risks of using leveraged real estate in your investment plan.
What is real estate leverage?
Essentially, real estate leverage is just a term for buying properties with borrowed money. By using leverage, you get to own the property without immediately paying the whole cost. (Which would otherwise usually require saving up hundreds of thousands of dollars!)
Most people use basic real estate leverage when they get a mortgage for their home. Let’s say you buy a $250k home, put $50k down, and get a mortgage for the remaining $200k. You’re leveraging the lender’s money in order to own the home.
Beyond single-home mortgages, there are other types of real estate leverage as well. So let’s kick things off by looking at five common kinds of leverage in real estate!
5 Types of leverage in real estate
When we talk about the different types of real estate leverage, we’re really just answering the question: “Where do you borrow the money from?” Different loan sources come with different eligibility requirements, terms, risks, etc. I’ll briefly cover the basics below!
We’ve already briefly touched on mortgages. Traditional mortgages are probably the most common leveraged real estate, since they’re used by nearly every homeowner.
You can get mortgage loans from a variety of financial institutions, from banks to credit unions to online mortgage lenders. Most mortgages come with a term of 15, 20, or 30 years.
Here are some different types of mortgage loans:
The right type of mortgage for you depends on your situation. For instance, FHA mortgages make homeownership accessible to first-time buyers with less savings required for down payments and lower credit scores. Jumbo loans might be good for experienced real estate investors looking to add an expensive property to their collection.
2. HELOCs or home equity loans
If you already own at least one property, a HELOC or home equity loan can help you leverage that first investment into more properties. HELOC stands for “home equity line of credit,” and essentially works like a credit card with the house as collateral.
A home equity loan, meanwhile, is sometimes called a “second mortgage.” Instead of having an open line of credit (like a HELOC), you get a fixed sum that you’ll repay over time.
So, let’s say you’ve paid off your first home, and now you’re interested in buying a second property. You can tap into that equity with a loan or HELOC, withdraw what you need for the new down payment, and pay it back monthly.
Be sure to also check out this article about using home equity loans to pay off debt.
3. Portfolio loans
You can choose to apply through a mortgage through a portfolio lender instead of a traditional mortgage lender. A portfolio lender is different in a couple of ways. They are often smaller community banks that don’t need to meet strict underwriting guidelines.
Portfolio lenders keep all their loans in-house, which means they take on more risk, and tend to charge higher rates. However, they are also more flexible and can be easier to qualify for, particularly for multi-property investors.
4. Private loans
Do you have good connections with people who are willing and able to back you financially? You can decide to arrange a private loan with them. It could be a friend, family member, professional connection, another real estate investor, etc.
If you pursue this option to buy leveraged real estate, make sure to draft a professional loan contract. Also, consider all the potential ramifications. Mixing money and family (or friendship) can get tricky, e.g. if you hit hard times and struggle to pay.
Before entering a private loan arrangement with a personal connection, check out these rules of loaning money to family & friends. (Although in this case, you’d be the borrower!)
5. Business lines of credit
Many real estate investors choose to leverage business credit to finance their properties. If you already own an established business, explore what lines of credit and loans are available to you.
It’s also possible to start your own real estate investment company and buy investment properties that way.
Businesses generally have more options for loans and lines of credit than individuals, as long as they’re profitable and have a good business plan. Beyond lines of credit, you can look into purchasing properties through SBA loans like a 504 loan.
However, if you don’t currently have a profitable business, this method will be out of reach until you’ve built a solid business credit score and history. It could be an option you can aspire to in the future!
4 Benefits of leveraging real estate
Why might you want to buy leveraged real estate? Here are some reasons:
1. Grow your real estate portfolio faster
With leveraged real estate, you don’t have to save up hundreds of thousands of dollars to buy new properties. Instead, all you need is a downpayment and the right loan. From there, as long as you can afford the monthly payments, you can own a lot of properties this way.
If you’re interested in owning real estate as an investment strategy, this can also help you diversify. Maybe you want to own a mix of residential and commercial real estate, or properties in different locations.
Most people rent out their leveraged real estate, so the rent payments cover their own costs plus some profit to spare.
For instance, maybe you want to buy housing in a college town to rent to off-campus students. Or a Main Street commercial space to rent to a small business. Or a property in a beautiful vacation spot to rent out to short-term travelers.
Whatever the case, be sure you run the numbers and make a plan before committing to the purchase. Compare the costs of similar rentals in the area. Talk to other owners. Brainstorm how you’ll market the property to tenants or visitors.
3. Profit from appreciating property values
Historically, appreciating property values have been a great source of wealth for a lot of people. If you take out a $100,000 mortgage to buy a property, and the value appreciates to $150,000 by the time you want to sell, that’s a cool $50k profit just for owning it!
Multiply that by several properties, and real estate leverage could really help fast-track your net worth in the right market.
4. Hedge against inflation
During periods of high inflation, the value of your dollars is steadily decreasing. That causes prices of goods and services to rise, so you lose purchasing power. You might notice inflation when your grocery bill gets higher even though you’re buying the same items.
But if you own assets like property, it can protect you against inflation. For instance, if you have a $200k mortgage, that’s a fixed amount that won’t increase with inflation. You’ll still owe the same monthly payment, and it doesn’t matter that the dollar has lost value.
4 Risks of real estate leverage
Sounding too good to be true? Good! Savvy investors should always consider the potential risks just as heavily as the potential benefits, if not more. So, let’s spend some time looking at what could go wrong…
1. Positive cash flow isn’t guaranteed
If you’re thinking about buying leveraged real estate in order to rent out properties, there are a lot of risks right off the bat.
What if your property doesn’t rent for months or even years? Or you have to lower the price to the point where you’re losing money or breaking even? Your tenants may not be able to pay if something happens. Or something could break, resulting in costly property repairs.
You also can’t forget to factor in loan fees and property taxes. Depending on your location, you could face significantly higher interest rates and taxes for non-owner-occupied properties. Be extremely thorough about researching what your real costs will be, and whether you can realistically expect a profit.
2. Property values can decrease
We’ve talked about how property values can appreciate, but there’s a flip side too. As anyone who bought property before the 2008 housing crisis will tell you, real estate can lose value too.
If you buy in a too-hot market, the value of the property may decrease later, sending you “underwater” on your loan. Essentially, that means you owe more than the house or property is worth.
And if you have multiple properties losing value, this can be extra financially painful. You might have to sell at a loss, or delay selling for longer than you wanted as you wait for market recovery.
There are also other factors that can cause your real estate value to depreciate. It could be physically damaged by weather or tenants. Crime rates could increase in the neighborhood. Even something like loud neighbors can affect what selling price a property can command.
3. It demands more hands-on work than other investments
Investing in real estate can be hard work. After all, you can invest in the stock market while sitting on your couch in sweatpants. With real estate, you have a whole laundry list of responsibilities. You have to:
- Do a ton of market research.
- Find the right properties.
- Save cash for down payments.
- Get the right loans.
- Make enough money to pay the loans.
- Find good tenants.
- Handle property maintenance, repairs, and improvements.
- Pay yearly taxes.
- Figure out if and when to sell.
For some people, all of this might be exciting! For others, it might sound like a stressful hassle. You definitely need to have the right personality and skills to invest using leveraged real estate.
4. You may lose a lot if you can’t pay
Last but certainly not least, this might be the biggest risk of leveraged real estate. You could very easily overleverage yourself and struggle to keep up with payments. There could be an emergency causing income loss or extra expenses.
Whatever the case, if you can’t pay, your lender can foreclose on the property. If that doesn’t recoup their full value, they may be able to come after your other assets too (depending on laws in your location).
Foreclosure hurts your credit score and ability to get future loans for years. It’s not something you want to go through, no matter how many properties you own!
Is real estate leverage right for you?
Using leverage for real estate investing isn’t right for everyone. However, if you’re in a situation where you can tolerate risk and it won’t ruin you if the market goes south, leveraged real estate can be a powerful part of an investing strategy.
Buying properties with real estate leverage isn’t the only way to make money from real estate! Learn more about real estate investing for beginners.