Leverage as defined in the lending industry is the use of borrowed capital to achieve a financial gain. Investors typically use leverage when they expect profits to be greater than the interest payable. Leveraging can significantly increase your overall cash on cash return when used properly. But what happens when you leverage too much and a deal goes wrong?
Let’s look at leverage in real world examples:
Sally has $125,000 to invest. Sally purchases a home for $100,000 and spends another $25,000 on repairs. If real estate prices drop and the home is now valued at $100,000, Sally has lost $25,000 (in addition to any maintenance, utilities, and holding costs), equaling a 20% loss.
Sally uses her $125,000 by putting down $25,000 on five properties worth $250,000 each. If real estate prices drop and each of these homes are now only worth $230,000, Sally has lost $100,000 (not including interest payments, holding costs, etc.), equating to an 80% loss.
Sally puts down $50,000 on two properties (a total of $100,000 down) worth $250,000 each. If real estate prices drop and each of these homes are now only worth $230,000, Sally has lost $40,000 (not including interest payments, holding costs, etc.), equating to a 40% loss.
Let’s look at leverage in another example in terms of leverage ratio (asset/equity):
Suppose Sally has $25,000 and borrows $225,000 to purchase a $250,000 home. She has a leverage ratio of 9:1, for every $9 of the asset, she has put in $1 of your own. If home prices rise 10%, the house is now worth $275,000, and after paying off her $225,000 loan, with the sale of her property, she made $25,000, a 100% profit on her initial investment.
The above scenario illustrates the advantages of leveraging when home values are favorable. However, when the market fluctuates and home values decrease, over-leveraging carries a higher risk.
What if home prices fall 20%? Then Sally suffers a 200% loss, losing her initial $25,000 and owes her lender an additional $25,000.
Leveraging can be a valuable asset in regards to real estate investing because of how the industry is designed to take advantage of it. With leverage, investors are able to purchase properties that may be priced higher than the cash they have available. However, when the market turns, those who over-leverage will be eradicated, while investors who use leverage appropriately may still be able to maintain the operations of their investment properties. Though the profit potential may seem tempting, over-leveraging can result in a loss on your properties and a default on your loan, so it is wise to consult a professional beforehand.