In the real estate investing world, the use of leverage when purchasing assets is a virtual certainty.
While it’s true that the excessive leveraging of assets has led to explosive outcomes when bubbles burst, using leverage wisely is an effective way for investors to increase their equity returns. In this article we discuss what exactly leverage is and what it isn’t, along with how to use it prudently in real estate investments.
Leverage is essentially the amount of debt that is borrowed to purchase in a property relative to the property’s current market value. The term loan to value ratio (LTV) can also be used when defining leverage. The loan to value ratio is exactly as its name implies: the value of the loan as a percentage of the value of the property.
When investors use leverage, they’re borrowing money that is repaid at an annual amount that is lower than the NOI (net operating income) of the property. In this case, the debt service coverage ratio (DSCR) for the asset is greater than 1. In rare cases, however, loans with a DSCR of less than 1 can be approved. If the debt payments are less than the net operating income of the property, the investor can service the debt with the building’s cash flow and collect the capital gains that are incurred during the hold period of the asset.
While the use of leverage on real estate assets sounds like a universally profitable idea, there are several benefits and risks to be aware of.
Benefits and Risks of Using Leverage
Leverage is commonly used to increase the potential return on investment of an asset. The use of leverage essentially allows real estate investors to get more bang for their buck—a major benefit.
Let’s walk through a basic example. If a real estate investor wants to invest $2 million in equity and decides to put 50% leverage on a property, the real estate investor is able to buy a $4 million asset. If the investor used 75% leverage instead of 50%, they could then buy an $8 million property.
Let’s say both properties appreciate by 10% in the first year and both are subsequently sold. Even though both assets started with the same amount of equity invested, the first asset generates a profit of $400,000 ($4.4mm-$4m) while the second asset nets a profit of $800,000 ($8.8mm-$8mm). While this simplistic analysis ignores the cost of servicing the debt (the larger loan would be more costly), it is illustrative of the ability for leverage to boost investment returns.
Higher levels of leverage can lead to higher profits but also involve greater risks. If the asset’s cashflows are materially lower than forecasted and the owner has taken on excessive leverage, they may struggle to meet debt obligations. In this case the owner of the property may need to refinance or even default on the asset. Because of the increased risk associated with providing greater amounts of leverage, higher LTV loans come with higher interest rates.
Using Leverage Wisely
It’s important to keep in mind that leverage is a double-edged sword when investing in real estate. During boom times, when interest rates are low and speculation is high, there are inevitably investors that take on excessive leverage and end up underwater on their assets. Undergoing thorough due diligence and investing prudently can help minimize the risks involved with the use of leverage, which will in turn boost your investment returns.