How investors use leverage in real estate to build wealth?
Financing a rental property using a down payment is a strategy real estate investors use to mitigate risk and maximize potential rewards. By spreading investment capital across multiple homes, investors can generate multiple cash flow streams and quickly grow a real estate investment portfolio.
However, there are pros and cons to everything, and leverage is no exception. Let’s discuss how using leverage in real estate can help you build wealth and how to avoid the pitfalls of using too much leverage to buy an investment property.
- Leverage in real estate combines a down payment with debt to increase returns.
- Conservative use of leverage helps investors to balance risk with potential reward.
- Leverage can be a double-edged sword and work for or against an investor.
- Using too much leverage results in a larger mortgage payment, less favorable loan terms from lenders, and an increased risk of negative cash flow.
What is leverage in real estate?
Leverage is a technique that real estate investors use to increase potential returns and build wealth over the long term. Also known as other people’s money (OPM), real estate leverage involves using debt plus a small amount of equity in the form of a down payment to purchase investment property.
For example, by making a $30,000 or 25% down payment on a $120,000 single-family rental (SFR) home, an investor collects 100% of the rental income and net cash flow, plus any profit from the increase in equity over the long term.
However, the real estate market and rent prices can go down as well as up, just like the stock market. That’s why it’s important to use leverage wisely when growing a real estate portfolio. A down payment can help investors avoid potential negative monthly cash flow if rent prices decline or vacancy rates increase and owning a property that is upside down if real estate values decline and the mortgage balance exceeds the property value.
How real estate investors use leverage to build wealth?
While there are various ways investors measure return—such as gross yield, cap rate, and annualized return or IRR—the financial return metric used in these examples is cash-on-cash return.
Cash-on-cash return is calculated by dividing net pretax cash flow (after all operating expenses and mortgage payments have been made) by the total amount of cash invested. To illustrate, if an investor earns an annual pretax net cash flow of $5,000 on a $100,000 rental property that was purchased for cash, the cash-on-cash return would be 5%:
- Annual pretax net cash flow / Total cash invested = Cash-on-cash return
- $5,000 pretax net cash flow / $100,000 total cash invested = .05 or 5%
Now, let’s look at how investors use leverage to increase returns and build long-term wealth over a 5-year holding period. We’ll consider 2 different scenarios: An all-cash purchase and a conservative 25% down payment.
For these examples, we’ll assume property values and rent prices increase by 8% per year, that operating expenses grow by 5% each year due to inflation, and that no additional cash is put into the property other than routine maintenance and repair costs that are included in the operating expenses.
All cash purchase:
|Year 1||Year 2||Year 3||Year 4||Year 5|
|Net Cash Flow||$10,080||$11,088||$12,187||$13,384||$14,688|
At the end of year 5, an investor paying all cash for the rental property is earning a cash-on-cash return of a little over 12% on the initial $120,000 investment. The property value has also increased from $120,000 to $163,259, representing a return of 36% if the property were to be sold, excluding closing costs.
25% down payment:
|Year 1||Year 2||Year 3||Year 4||Year 5|
|Net Cash Flow||$4,368||$5,376||$6,475||$7,672||$8,976|
At the end of year 5, an investor using leverage to purchase the rental property is earning a cash on cash return of nearly 30%, more than 2.5 times greater than the investor who paid all cash.
The property value has also increased to $163,259, for an equity gain of $43,259, representing a return of 44% ($43,259 equity gain / $30,000 down payment), excluding the reduction in mortgage principal balance from the monthly mortgage payments, which would increase the rate of return, and sale closing costs that would lower the return.
A free online tool for calculating potential returns
The above examples used very basic assumptions, such as rent prices and home values consistently increasing by the same amount year over year, and the property never needing capital repairs. But in the real world of real estate, returns are never the same each and every year. For example, rent prices might increase more than anticipated, or it could take longer than planned to find qualified renters to lease a vacant home.
You can use the free rental property analyzer in this article to forecast the potential return of a property. Simply enter some information to view projected key return on investment (ROI) metrics, including cash flow, cash-on-cash return, net operating income, and cap rate.
Investors can use different down payment amounts and interest rates, and change other variables like estimated rent and vacancy rate, to forecast the potential return of any property.
The potential pitfalls of using too much leverage
While using leverage can boost potential returns, it’s also possible to have too much of a good thing. Although making a down payment as small as possible will significantly increase cash-on-cash returns, a larger mortgage payment also reduces the amount of net cash flow.
The example below shows 2 different down payment scenarios. The first column assumes an investor uses a 25% down payment to purchase a rental property, and the second column assumes a down payment of 10%:
|25% down||10% down|
|Net Cash Flow||$4,368||$2,844|
In this example, the smaller down payment generates a cash-on-cash return of more than triple the return from a larger but more conservative down payment. While a cash-on-cash return of almost 50% may be pretty impressive, there isn’t a big margin for error.
Note that the net cash flow from the highly leveraged property is equal to about 2 months worth of rental income. If it takes longer than expected to find a qualified tenant, or if an unexpected repair needs to be made, an investor could have little or no return, as illustrated in the third column:
|25% down||10% down||Pitfall of Leverage|
|Net Cash Flow||$4,368||$2,844||$44|
Tips for using leverage to increase returns
Owning a rental property with little or no cash flow isn’t a good situation to be in. Here are some ways to balance risk and reward when leveraging real estate to build wealth:
- Don’t assume that past performance guarantees future results. Rent prices and home values sometimes decrease, and expenses may be higher than expected.
- Use a conservative down payment on a rental property of at least 20% to balance risk with reward by having a manageable mortgage payment and a healthy amount of positive net cash flow.
- Consider that making a small down payment may also increase financing costs, such as a higher interest rate, large loan fees, and private mortgage insurance (PMI).
- Create a capital expense (CapEx) account by depositing part of the rental income each month into a separate “rainy day” fund to have extra funds on hand when the unexpected occurs.
Remember that leverage creates risk as well as reward. Leveraging real estate to increase potential returns can help investors build wealth, provided a reasonable down payment is used. While it’s easy to be optimistic and think only about good things, such as rising rents and home value, a downturn could be just around the corner. Be sure to spend enough time thinking about worst-case scenarios to avoid being caught off guard.
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