Understanding smart debt management is key for ROI as a real estate investor. Real estate investors utilize leverage to amplify returns, but it entails risks. Leveraging borrowed capital allows access to higher-value properties and potential long-term wealth. However, without guaranteed appreciation, negative leverage or high mortgage payments can lead to financial setbacks. Savvy investors understand that smart strategies involve assessing risk tolerance, due diligence, selecting suitable lenders, and preparing for market fluctuations.
As a real estate investor, you know that taking on debt is a calculated risk. If you want to earn big returns, you need to figure out the level of risk you’re comfortable taking on. But finding the right balance between risk and reward can be tricky. If you take on too much debt, you could find yourself in a deep hole that’s difficult to climb your way out of.
Using leverage to your advantage can help you make smart decisions to increase your potential return on investment (ROI). Here are some tips that can help you figure out how to strategically use leverage in your favor.
What Is Leverage In The Real Estate World?
In real estate, leverage refers to the use of debt or borrowed capital to increase the potential return on an investment. Many savvy real estate investors use leverage to build long-term wealth.
By using leverage, a real estate investor can buy more expensive and lucrative properties and scale their real estate holdings considerably. They use this technique, often referred to as “other people’s money” or OPM to decrease the amount of capital they need to buy a new real estate property.
Types Of Real Estate Leverage
There are different forms of leverage a real estate investor might use. There are different layers of debt they can take advantage of, including second mortgages and mezzanine financing. They can also use home equity loans or home equity lines of credit (HELOCs) to access equity in existing properties.
Additionally, they may access private loans, hard money loans, or non-recourse loans to get the financing to buy more expensive properties. In some cases, a business credit card may be used, though this type of leverage can be riskier.
The Benefits Of Real Estate Leverage
If you’re considering using leverage to bulk up your portfolio, here are some pros to keep in mind:
- Access to additional funds: Using leverage to get more money upfront can open up access to higher-value properties.
- Increasing your potential returns: When done correctly, leverage can help you earn more on the properties you purchase.
- Ability to scale wealth long term: Leverage can help you build wealth for decades to come if you continue using this strategy to purchase new properties.
The Risks Of Real Estate Leverage
But this investing strategy also has some real risks you should keep in mind, including:
- No guarantee of high appreciation: The real estate leverage strategy assumes a high level of appreciation — but there’s no way to predict future success. If real estate values begin to decline, your strategy can tank quickly. Even if you’ve had good luck with this strategy in the past, it’s always a gamble.
- Negative leverage: If your annual debts become higher than the income you’re earning, you’ll find yourself losing money on your investments and spiraling down into a financial hole.
- Bigger mortgage payments: Buying more expensive properties almost always comes with higher mortgage payments. This can be a red flag for lenders who might give you unfavorable mortgage terms.
Tips For Creating A Smart Real Estate Leverage Strategy
1. Know your risk tolerance
This is essential before jumping into any type of real estate leverage method. You’ll want to calculate your expected debt-to-capital ratio — the amount of borrowed money to the overall amount of money you’re working with.
Think of this as the share of your investment that is reliant on debt. If your ratio is high, it means you’ll have to pay back a large portion of your return. A high ratio could increase your overall return, but it also increases your risk.
For example, let’s say you borrow $50,000 and invest $30,000 of your own money from your business bank account. The formula to find your debt-to-capital ratio would look like this:
$50,000 / ($50,000 + $30,000) * 100 = 62.5%
So 62.5% of your investment is funded on debt you’ll have to pay back.
The right percentage for you will depend on your financial goals and investment strategy. It can be helpful to talk to other real estate investors who use debt to build their portfolios.
2. Perform Due Diligence
When using leverage, you have to put an added emphasis on due diligence. This involves working with an experienced inspector to survey the property, so you have the full scope of any current or potential problems — or money pits.
Due diligence also includes doing comparative analysis to better understand the local real estate market and values for comparable properties. You should also be sure you’ve thoroughly checked your financial analysis, so you understand the potential ROI and appreciation over time.
3. Choose The Right Mortgage And Lender
Lastly, be sure to review different mortgage lenders to find the right financing option, interest rate, and terms for your investment. Depending on the amount of leverage you’re utilizing, you may be faced with less-than-desirable mortgage terms. In this case, be sure to shop around to find a lender that better suits your needs.
Look for low interest rates, no or low fees, and repayment terms that align with your projected revenue plans. Make sure you also account for other fees like realtor commissions.
Find The Right Investment Opportunities For Your Goals
Once you know you’re certain you’ve performed your due diligence, it’s time to focus on the best investment opportunity for your leverage strategy. You may want to identify areas that are underdeveloped and expected to grow in the near future or undervalued to ensure you don’t overpay.
You can use job growth and population data to help narrow down the right areas and buildings to fit your specific goals, whether you invest in residential rental units or commercial real estate properties.
Most real estate experts recommend launching your leverage strategy in a growing market, rather than a declining one, to avoid potentially losing money on your investment. Making sure the economy is strong and home values are expected to continue rising are two good indicators to look for.
And be prepared in case your investment strategy doesn’t go according to plan. You should always be sure to account for any fluctuations in the market. If the economy went into recession, for instance, could you stay afloat by selling your property? Thinking through all possible scenarios can help you better prepare for an unpredictable investment.