One of the most useful tools a real estate investor can use is leverage, but it’s easy to become overleveraged if you aren’t careful. Using leverage is a clever strategy that allows new investors to break into the world of real estate investing without needing to put up a bunch of money upfront. If done wisely, investors could multiply their initial capital and work toward building long-term wealth.
When an investor uses leverage as it’s intended, they might find that they’re able to increase returns and build equity pretty quickly. This, of course, allows the investor to purchase other properties and… rinse and repeat.
As easy that may sound, you run the risk of becoming overleveraged when the market shifts, property values drop, and interest rates increase. All of these factors can throw off your entire investing strategy and out you in the red.
Risks of Becoming Overleveraged
Leverage can be a useful tool for the savvy investor, but you have to be aware of the potential risks too. To understand those risks, let’s say you have $100,000 cash and want to begin investing.
Here are three possible scenarios:
Note: For the point of these examples, we’ll say property values increase by 11.4% (the national average for 2022).
Zero Leverage (All Cash Payment)
You use the full $100,000 to buy the property, thus you have no mortgage. After one year, the property is now worth $114,000.
- You have gained $11,400 from that initial $100,000 investment.
50% Leverage (50% Down Payment)
You put the $100,000 down on a property that’s worth $200,000. You now have a mortgage for the remaining $100,000. After one year, that property is now worth $222,800.
- You have gained $22,800 from that initial $100,000 investment.
75% Leverage (75% Down Payment)
You split the $100,000 and purchase two properties, each valued at $200,000. You are now financing $150,000 for each property ($300,000 total). After one year, the total value of both properties equals $445,600.
- You have gained $45,600 on that initial $100,000 investment.
As you can see, there’s the potential to grow your wealth pretty quickly if you strategize correctly. Now, let’s look at those risks of overleveraging.
1. Cash Flow Woes
It’s a good idea to concentrate on property management elements to increase real estate ROIs. However, using such a strategy could make you forget about the cash flow. Money, not actual assets, should be the primary language of a real estate investor.
The likelihood is that you won’t be able to effectively track where your money is going if you ignore the cash flow. This danger has a rather easy fix. Determine the location of the money you are investing. Plan which expenses they will be given and how they will be converted into ROI.
2. Fluctuating Appreciation Rates
It’s dangerous to invest in a property simply because you’re anticipating that the property’s value will appreciate in value. A property’s value may appreciate year-over-year for several years, but if the market crashes or stagnates, then your investment could turn into a loss.
A property’s value might increase depending on a variety of reasons, most of which are unpredictable. Instead of anticipating that the property will appreciate each year, focus on in-demand home improvements to raise the property’s value.
3. Buying Another Property Before You’re Ready
Investors are likely to try their hand at many properties while using debt to increase ROI. If you have the money, you can do the same, but bear in mind that it’s a big risk that risky course of action.
You’ll have multiple mortgages to pay off if you’re using leverage for each investment property. Realistically speaking, there is the potential to have an investment that isn’t going to investment yields a return in the long run. But, depending on your area, the likelihood of having more than one or two properties underperform is rare.
4. Multiple Mortgage Payments
Mortgages enable the majority of leverage in real estate investments. You run the danger of having to make a higher monthly mortgage payment if you’re financing a purchase.
This might not be an issue if you’re fixing and flipping some of the properties, but if you intend on turning all of them rental properties, you might have to pay the mortgage out of your own pocket if there’s a prolonged vacancy or if you have tenants that don’t pay on time or at all.
How to Use Leverage Wisely
Despite the potential risks of leveraging debt to purchase property, this strategy can nevertheless provide a profit, as long as you remember that there aren’t any sure bets when it comes to investing. It’s crucial that you’re sensible and have a plan.
Here are a few tips to avoid getting overleveraged.
1. Find the Right Market
Before buying any real estate, you have to do your due diligence to make sure you’re investing in a good market. To figure out the best places to go, you’ll want to look at an area’s property value trends — a trusted real estate agent can help you with this.
2. Know Your Monthly Budget
Once you understand how to leverage to make investments, you shouldn’t make the mistake of making the smallest down payment possible because it could be tough to maintain a higher monthly payment later down the road.
You have to plan your spending properly, so you’ll want to try to strike a balance between your down payment and the mortgage payment. Also, you’ll need consideration other factors that could impact your budget, like poor tenants, a poor economy, and decreased vacancy rates.
3. Don’t Rely on Appreciation
Even though rents and property prices have been rising recently, there are no guarantees that this upward trend will continue. As an investor, you need to be cautious when estimating the appreciation you expect from your investment property mortgage. It’s a good idea to set your financial goals with a somewhat lower expectation in mind. Of course, it’ll be a pleasant surprise if your returns are higher than you’re expecting.
4. Have a Rainy Day Fund
Don’t forget to set up a contingency fund when using real estate as leverage! When your rental income is not enough to pay your mortgage, building a nest egg will help protect your investment.
5. Diversify, Diversify, Diversify
If you own several cash-flowing investment properties, one of the properties’ cash flow may be able to cover the other’s monthly costs. You don’t want to put all your eggs in one basket, after all.
Overleveraged: The Wrap Up
The main strategy successful investors use to speed up portfolio growth is real estate leverage. But, even though it’s tempting to put down as little money as possible on a property, you’re putting yourself in a risky position. In the unfortunate event where there’s changes in the market, tenants falling on hard times, or you’re unable to fill a vacancy, your mortgage(s) will still have to be paid. And you need to be prepared for that.
The truth of the matter is, savvy investors know that in order to use leverage effectively, it’s crucial to have an investment plan that includes a some precautions to help prevent them from becoming overleveraged — and you should too.
