Leverage in Real Estate: How Does It Help Investors?

The Big Picture On Using Leverage In Real Estate:

• • In real estate, leverage allows investors to purchase properties using borrowed money, typically putting down only 20% of their own cash.
  • Using leverage can amplify returns. For example, a $200,000 property bought with 20% down could yield a 14.6% cash-on-cash return versus 7.5% if bought outright.
  • There are multiple types of leverage available, including traditional mortgages, portfolio loans, HELOCs, business credit lines, and private notes.

What do investors mean when discussing “leverage” in real estate, anyway?

It may sound jargony, but real estate leverage is actually a simple concept and one of the great advantages to real estate investments over other asset classes.

However, it also comes with risks, so make sure you understand how to use it before going wild with debt.

What Is Leverage in Real Estate Investing?

Leverage in real estate is, quite simply, the ability to use other people’s money to buy your own assets. These assets generate ongoing income for you and appreciate over time.

For example, when you buy a rental property, you can often borrow 80% of the purchase price from a mortgage lender. You only come up with 20% of the price on your own.

Contrast that against stocks, where brokerages don’t allow nearly the same extent of leverage. Even when they let you buy on margin, they often only lend up to 50% of your portfolio balance at high interest rates. Worse, they can “call” the leveraged stocks you bought on margin if the stocks go down in value. In other words, they can force you to sell at a loss (a margin call).

That doesn’t happen in real estate investing.

How Real Estate Leverage Helps Investors

Leverage helps real estate investors by reducing the amount of cash they need to buy a property.

At the time of this writing, the median home price in the US is $374,900. Imagine coughing up all that money in cash to buy a rental property! Only the wealthy could afford to invest in real estate.

But the advantages of leverage in real estate don’t end there.

Amplified Returns

Leverage can also improve your cash-on-cash return on a property. For example, imagine you buy a rental property in cash for $200,000 that rents for $2,500 per month. Assuming non-mortgage expenses at half the rent (the 50% Rule), your total monthly net cash flow comes to $1,250 per month or $15,000 per year. That offers you a return of 7.5% ($15,000 / $200,000): not too shabby, but hardly a home run.

Now imagine you instead taking out a 30-year rental property mortgage for $160,000 at 4.5% interest, which adds a monthly principal and interest payment of $764. That cuts your net monthly cash flow to $486 for an annual cash flow of $5,832.

But you only put down $40,000 in cash, not $200,000. Your cash-on-cash return is, therefore, 14.6% — nearly double what you’d get if you’d paid cash for the property.

Use our free rental income calculator to calculate returns, cash flow, mortgage payments, cash-on-cash returns, and more.

Scaling Your Real Estate Portfolio

To truly grasp the scope of the difference, imagine two investors, each with $200,000 in cash to invest in rental properties.

One buys the above property in cash, while the other takes out rental property mortgages and buys five identical properties. At the end of their first year, the one who paid cash for a single property had $15,000 in net earnings. The one with five properties has almost twice that,$29,160 ($5,832 x 5 properties).

After the second year, the cash flow rises to $50/month per property. The investor with one property walks away with an extra $600 at the end of the year, while the investor with five properties ends up with an extra $3,000.

And so on, with returns compounding fivefold with every year that goes by.

Don’t forget property appreciation, either. Imagine the properties appreciate at 4% per year on average: each property is worth $296,049 after ten years. The investor who bought one property in cash earned $96,049 in appreciation.

The investor who bought five properties earned $480,244 in appreciation.

And that says nothing of strategies like the BRRRR method that let you pull all of your cash back out of properties to keep reinvesting over and over again.

Starting to understand the power of leveraging other people’s money to build your real estate portfolio?

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Types of Leverage in Real Estate

There are several ways to leverage other people’s money to invest in real estate.

Here are a few of the more common ones, along with a couple of not-so-common ideas as well.

1. Traditional Mortgages

When most people think of leverage in real estate, they first think of traditional mortgages because that’s how they bought their primary residence.

On the plus side, these lenders offer low interest rates and reasonable lender fees. If you house hack, you can use owner-occupied financing for a minimum down payment and lower interest rates. You can take advantage of down payments of around 3% with Fannie Mae house hack loans, FHA loans, or VA loans.

But they have plenty of downsides. First, they’re slow—it usually takes 30-60 days to close a loan.

Second, they report to the credit bureaus. That may not sound like a problem until you understand that they also limit the number of mortgages you can have appearing on your credit report. In most cases, they allow a maximum of four mortgages, putting a hard limit on how many traditional mortgages you can borrow.

Consider going through a traditional mortgage broker for your first rental property or two. Try Credible to compare interest rates in your area.

But after your first few deals, you must graduate to portfolio lenders.

Key Features of Traditional Mortgages

While we’re at it, here are the important characteristics of traditional mortgages that potential borrowers should consider.

2. Portfolio Loans

Traditional mortgage lenders sell off nearly all their loans immediately after closing them. In contrast, portfolio lenders keep their loans in-house for the entire life of the loan — keeping them on their portfolio.

They’re faster and more flexible than traditional lenders and make lending decisions based more on the quality of your deal than on you as a borrower. They still check your credit, but they often don’t verify your income.

A few of our favorite portfolio lenders include Kiavi, Visio, and LendingOne. However, on our Loans page, you can compare the interest rates and loan terms of all the major rental property mortgage lenders.

3. HELOCs

A HELOC, or home equity line of credit, is exactly what it sounds like a rotating line of credit secured against a property. Think of it like a credit card that you can draw on, but if you default, they take your property.

Most people think of HELOCs against their home, their primary residence. But you can take out a HELOC against a rental property too.

You can draw on HELOCs to potentially cover your next property’s down payment in cash, or pay for repairs or renovations, or any other real estate investing costs.

Then, pay back your HELOC balance on your own schedule, as quickly or slowly as you like.

You can open a HELOC with Figure in five days, and they offer HELOCs against investment properties, second homes, or primary residences.

4. Business Credit Lines & Cards

Many real estate investors don’t realize it, but they qualify for business credit cards and credit lines.

Unfortunately, most don’t know how to apply for maximum credit limits, how to negotiate higher limits, or where to find the best introductory offers and lowest interest rates. Or, for that matter, how to scrub their credit report and then open more lines.

We recommend speaking with Fund & Grow to do all of the above for you, to open between $50,000 and $250,000 in credit lines as a real estate investor.

Note that as business credit cards and credit lines, they aren’t secured against any of your properties. This means you don’t have to pay for title searches, record liens, or risk losing properties to foreclosure in the event of a default.

Like HELOCs, you can use these credit lines to buy properties outright, cover the down payment, pay for renovations, or build your investing business by paying for mailers or other marketing strategies. Business credit offers even more flexibility, as you can repay the balance at your own pace with a low minimum monthly payment.

For an overview of how the process works, check out this free webinar we hosted with Fund & Grow.

5. Private Notes

Many of the most advanced real estate investors raise money through private notes rather than borrowing from a lender.

A “note” is simply the legal document that a borrower signs, promising to repay a loan. Private notes are exactly what they sound like a private loan from one individual to another.

You could borrow money from friends or family members, colleagues, or other real estate investors. I myself lend money to other real estate investors I know and trust at a 10% interest rate.

Why would anyone borrow money privately at 10% interest, rather than borrowing at 4-5% from a portfolio lender?

Flexibility, to begin with. They can put my money toward any of their current projects. I also charge interest only: the loan is not amortized over 30 years. So they keep the principal and keep investing it, paying me interest once a quarter.

Many private lenders don’t charge fees or points, unlike lenders in business.

Ultimately, all of the terms are negotiable. That goes for points and fees, interest rates, and loan term. As you establish a track record of success, your friends and family members might throw money at you and charge appealing interest rates with no upfront fees.

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Want to compare investment property loans?

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We compare several buy-and-rehab lenders and several long-term landlord loans on LTV, interest rates, closing costs, income requirements and more.

Risks of Overleveraging Real Estate

Leverage is a tool, and it cuts both ways. It can boost your potential return when you score a fantastic deal — or it can leave with a lower cash-on-cash return, possibly even a negative one.

Lower or Negative Cash Flow

While leveraging other people’s money amplifies your returns, it steepens your losses on low or negative returns. Let’s take another look at the example above, but this time, assume a lower rent and cap rate.

Say that $200,000 property rents for $1,600 monthly, not $2,500. By the 50% Rule, your net cash flow drops to $800 per month or $10,800 per year. If you bought in cash, you’d earn a return of 4.8% ($10,800 / $200,000).

Now, say you took out that same mortgage outlined above, with a principal and interest payment of $764. Your monthly cash flow drops to $36, or $432 per year. That puts your cash-on-cash return at 1.1% ($432 / $40,000).

If the property is rented for $1,500/month, you will lose monthly money if you borrow a rental property mortgage. Likewise, you’d have negative cash flow if you paid 5.5% interest instead of 4.5% interest.

Then imagine you have a vacancy at the property and really lose money each month—or worse, four vacancies all at once.

Loss of Both Real Estate & Personal Assets

If you default on your rental property mortgage, the lender forecloses and takes your investment property.

But they don’t stop there — most require you to sign a personal guarantee on the mortgage, so they can come after all your assets if you default. Personal assets like your home, your car, your checking account, your brokerage account, your engagement ring, and so on.

Upside-Down Properties

Contrary to popular delusion, property values don’t always go up.

Most properties in most real estate markets rise in value in most years. As anyone who lived through the housing bubble in the late 2000s can tell you, however, “usually” offers cold comfort for people watching their property plummet in value.

Which is no fun even if you don’t have any real estate loans and own your property free and clear. But when you do have a mortgage and real estate prices drop, it can leave you upside-down on your property. In layman’s terms, being upside-down means owing more than the property is worth. That makes selling extremely difficult, at least without coughing up money to cover the difference.

Real estate leverage comes with risk.

Tips for Using Leverage to Your Advantage

Leveraging your investments is a surefire way to gain wealth in real estate. However, as with any investment, it’s important to approach it wisely. Worry not; below are realistic tips to help you use leverage to your advantage:

Conservative calculations – Always use conservative numbers when calculating real estate cash flow. Run numbers with the lowest possible rent and highest possible expenses to avoid committing to a property that loses money.

Avoid no down payment – Don’t attempt to purchase a property with no down payment. Down payments protect both the lender and you from overleverage.

Resist over-borrowing when starting – When beginning your real estate investment journey, resist borrowing excessively, even if cash is tight. Mistakes are costlier when amplified by leverage.

Learn fundamentals first – Focus on learning the basics of real estate investing before using high leverage. Start with less leveraged properties to gain experience.

Consider house hacking – If cash is limited, try house hacking as an initial strategy. This provides some margin for error compared to paying full price for housing.

Scale gradually – As you become more proficient and consistently buy profitable properties, you can leverage other people’s money more to expand your portfolio.

Exercise discipline – Saving up more cash to invest initially requires discipline. Remember that individuals lacking discipline should avoid investing in rental properties altogether.

FAQs About Leverage in Real Estate

How much leverage is too much?

Too much leverage depends on individual circumstances, but generally, over 80-85% loan-to-value (LTV) is considered high risk. Factors like cash flow, interest rates, and market conditions affect what’s “too much.” Maintaining 70% or less should be ideal.

What is the ideal debt-to-equity ratio for real estate investments?

There’s no universal ideal ratio, but many investors target 1:1 to 3:1 (debt-to-equity). This translates to about 50-75% LTV. However, the “ideal” depends on many factors like risk tolerance, investment goals, market conditions, etc.

How does leverage affect cash-on-cash returns?

Leverage can improve cash-on-cash returns by reducing the initial cash investment. For example, a 10% unleveraged return could become 20% with 50% leverage, assuming the property’s income exceeds debt service costs. However, leverage also increases risk if property values decline.

Final Thoughts

Like any tool, leverage in real estate can be wielded with skill to produce better results, or it can be dangerous.

I overleveraged myself on a buying spree early in my real estate investing career, which cost me hundreds of thousands of dollars.

Rather than trying to get clever and buy rentals or flip houses with no money down, save up some investing capital and master the fundamentals first. Then, you can get creative with using other people’s money to build a real estate empire without much of your own cash.♦

What mistakes have you made with real estate leverage in the past? What are your biggest questions about leverage in real estate investing?

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