Real Estate Financing and Investing/Should You Use Leverage When Investing in Real Estate
Leverage means use of other people`s money (OPM) in an effort to increase the reward for investing. To a lot of people, it means risk. The fact of the matter is, using leverage in real estate investing is an exciting way to earn big yields on small dollars, and you should not fear taking a chance. When you are building real estate wealth, leverage will help you grow quickly without involving too much risk (as long as you watch out for some pitfalls, which will be discussed later). High leveraged investing in real estate is especially powerful when inflation is in full swing. High leverage investors have numbers going for them because property values rise faster than the interest charges on their borrowed money.
To see the full power of high leverage investing, take a look at the following example:
You pay a seller $100,000 cash for a piece of property. During the next 12 months, the property appreciates 5 percent and grows in resale value to $105,000. The $5,000 gain equals a 5 percent yield on your investment. But suppose you had put down only 10 percent ($10,000) in the property and mortgaged the balance. Now, your return on investment leaps to an astonishing 50 percent! ($5,000/$10,000). Another way of looking at the result is: Since you only put down $10,000 on $100,000 worth of property, you actually control the asset 10 times the value of your actual cash outlay. This means 5% x 10 times = 50%. (In this example, for simplicity, we`ve omitted mortgage interest costs as well as the return on the $10,000 you would have invested somewhere else, plus any rental income you would have earned from the property).
Let us expand the scenario to further see the impact of leverage.
Instead of putting 100% down ($100,000), you put down 10% ($10,000) and bought nine more pieces of property, each costing $100,000, and each bought with 10% down ($10,000). Again assume that they appreciate at the rate of 5 percent. Therefore, your wealth increases: $5,000 a piece x 10 pieces = $50,000. All that in one year.
Tip: Tying up your wealth in one property ($100,000) cost you $45,000 ($50,000 - $5,000). Conversely, by spreading your funds over more properties and leveraging the balance, you would multiply your earnings 10 times.
Remember: The lower the amount of cash invested, the higher your return (from value appreciation and/or rental income). On the other hand, the larger your cash investment, the lower your return. Also, remember, a higher appreciation will greatly increase earnings on your leveraged investment.