How to Leverage Real Estate

Adding real estate to your portfolio can diversify your assets, provide passive income, and increase your overall net worth. It’s a great way for many investors to reach their financial goals and grow their wealth. As more and more Americans choose to rent their homes instead of purchasing them, it’s a great time to get into the rental property business.

However, only some investors have the capital to buy a property outright, so many individuals choose to leverage real estate. While utilizing leverage, investors use borrowed capital, or debt, to increase their overall return on investment. Essentially, you go into debt for a short period to increase your returns in the long run.

What is Leverage in Real Estate?

If you buy an investment property that you rent out, you can add passive income to your portfolio. Plus, the property's value may increase so that you could sell it at a profit. However, a decent property will cost hundreds of thousands of dollars, and many investors aren’t able to invest that much capital upfront. That is where leverage real estate comes in.

Instead of buying a property outright, investors can get a loan to finance the property. They’ll go to a lender, such as a bank, private lender, or mortgage broker, to take out a mortgage. Investors then use this loan to purchase the property. The investor will pay the debt back over a predetermined period with interest.

How Does Leverage Work?

Leverage is simply borrowed capital. Investors use this borrowed capital to pay for assets, such as property, when they don’t have the capital to cover the initial investment. To leverage real estate, investors will typically take out a mortgage.

First, investors will need to identify a lender. A second or rental property mortgage is more difficult than a primary residence. You’ll likely need a smaller debt-to-income (DTI) ratio and expect to pay more interest. The loan may also be over a shorter period. Lenders will look at your debt-to-income (DTI) ratio, credit history and score, and potentially your other assets to determine how much they can approve.

Once the loan is finalized and signed, you’ll have to pay a down payment to the property’s seller. For second or additional properties, you may be expected to pay up to 25% of the closing costs as a down payment. Your loan will cover the rest of the price.

You can use the rental income to pay off the monthly mortgage. Although it may decrease your returns for the first few years, once the property is paid off, you’ll be able to pocket most of that income as profit. 

Real Estate Leverage Example

Real estate leverage can also help you grow your overall portfolio. For example, let’s say you purchase a commercial property to rent out and increase your passive income. You identify a property that you think will be a fruitful investment, but it costs $1 million, and you can’t invest that much capital all at once.

So you take out a mortgage for $800,000 and pay $200,000 as a down payment. A reliable tenant rents out the property, and you use their rental income to pay off the mortgage. The property continues to rise in value, and you pay off the mortgage, giving you full ownership of that commercial property.

Now, you’re looking to buy another investment property. You can leverage your increased equity in your first property to secure funds to purchase a second property through a home-equity loan. And you don’t even need to sell the initial property! Now, you have two properties generating income, which you can use to continue growing your portfolio. 

Ways to Access Leverage

There are several ways to access leverage, such as using your equity or borrowing from a lender. You may qualify for a home-equity loan if you already have properties. These loans use the equity of your property as collateral for the loan, allowing you to tap into your home’s value to finance the purchase of another property. Home equity loans typically have lower interest rates than other loans and mortgages, making them a popular choice for responsible borrowers. However, it’s important to remember you’re risking your property if you can’t repay the loan, so ensure you can commit to the repayment terms before taking out a home-equity loan.

The other route is to seek out a financial institution or private lender to loan you the money for the property. The borrower will check your credit score and debt-to-income (DTI) ratio to determine how much they can loan and at what interest rate. There will be a set repayment term in which you must pay back the debt.

Another option is seller financing. Some sellers will handle the mortgage process instead of going to a financial institution. You’d be signing a mortgage with the seller themselves instead of borrowing from a third-party financial institution to cover the cost of the property. You’d pay the property's price in installments over a set period, with interest, much like a mortgage. Seller financing tends to be more flexible, but it’s also less regulated.

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Potential Risks of Excessive Leverage

Using leverage in real estate is a great way to increase your purchasing power and earn higher returns on your investment. However, it is still a risky venture. For example, if the market has a downturn after you purchase a property, you could be paying more for a property that has decreased in value. If the property’s value dips below the amount you paid on the mortgage, plus interest, you could lose money on the investment. 

It’s also important to note that you won’t fully own the property until the loan is paid off. So, if you fall behind on payments, the lender can take possession of the property. Before purchasing a home and taking out a mortgage, ensure you’ll be able to make enough rental income to make your monthly payments.

Tips for Using Leverage to Increase Returns

If you use leverage to finance a property, you must be cautious to give yourself the best chance at positive returns. First, you should plan on a conservative down payment. The more you pay upfront, the less you’ll have to borrow. You may also get better mortgage terms if you spend a higher down payment. 

Before purchasing a property, you should carefully plan to ensure the investment will produce the desired returns. Calculate the impact on your finances with careful numbers. If you use ambitious numbers, you may need more time to cover unplanned numbers. But by using safer numbers when calculating potential income and expenses, you’ll be better prepared to ride the highs and lows.

Rental properties require active management. They’ll need routine maintenance, demand unexpected repairs, and incur management and real estate expenses. Potential landlords need to prepare for these expenses, and the best way to do so is to open a capital expenses account. You can put money from your monthly income into the account and use it to cover costs associated with the property.

Increase Your Buying Power

There is inherent risk whenever you take out a loan or go into debt. However, with careful planning, leveraged real estate can significantly increase your buying power to help you improve your wealth over time. Going momentarily into debt could allow you to purchase a property to increase your equity and monthly income. Leverage makes real estate much more accessible to investors who can’t afford to buy a property in cash. Consult a trusted advisor to see if using leverage to invest in real estate is a good fit for your portfolio.

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