Have you ever wondered how certain people are able to go from having relatively little money and zero investments to having a booming real estate investment portfolio in a matter of just a few years? In most cases, it comes down to the powerful concept of leverage. But as great as leverage is, it’s easy to become over-leveraged and destroy your finances. The key is to understand how to do it appropriately.
According to the Forbes Real Estate Council, “Leverage is generated by using borrowed capital as your funding source when you invest. This allows you to buy a much larger asset and increase the potential return on your investment than you could if you had to pay 100% of the purchase price upfront. As real estate experts like to say, leverage enables you to make money on other people’s money.”
That sounds pretty straightforward in principle, but what does it actually mean? In other words, how do you use the power of leverage to increase your returns and maximize your potential?
The best way to understand leverage in practice is to look at some examples. Consider three different scenarios in which you have $100,000 to put toward a real estate investment:
Now let’s say that property values increase by 7 percent in a year. If you were to look over the financials of each scenario after the property values appreciate, here’s what you would find:
The beauty of leverage – and bank financing – is that each of these deals can be initiated using the same $100,000 in cash. The returns range from 7 percent to 28 percent – dependent on the amount of leverage used.
In theory, using leverage in real estate investing sounds like a no-brainer. The problem is that the real world is far from perfect. If you aren’t careful, you can quickly become over-leveraged, which is a scary place to be. But you can typically prevent this danger by avoiding the following mistakes:
Leverage is tempting. Sometimes it makes sense and other times it exposes you to unnecessary levels of risk. It’s up to you to make the right decisions.
Leverage is powerful, but it must be used strategically. You have to continually be on the lookout for the right conditions and ready to turn down deals that don’t meet your stringent requirements. This is why proper due diligence is so important.
The Forbes Real Estate Council encourages investors to ask questions like, “How have property values trended in the area? What known factors, like the arrival or departure of a major employer, will influence the economy in the months, years and decades ahead? What are the expectations for the broader regional and national economy for the foreseeable future? The answers to these and related questions are critical.”
Secondly, you need a clear and unwavering investing strategy. Whenever you’re considering buying a property, ask yourself whether it’s a short-term or long-term play. Based on this answer, you can develop a set of factors and rules regarding when you exist the investment and when you stay put. Thus, when the market starts to change, you don’t have to stop and think.
Thirdly, use common sense. If your gut tells you that you’re taking on too much risk with too little potential for reward, walk away. Real estate investing always comes with some inherent risk, but there needs to be a limit on how much you’ll accept.
At Green Residential, we’re in the business of helping Houston-area homeowners, homebuyers, and real estate investors maximize their assets and make smarter decisions in how they buy, sell, and manage real estate. For more information on our services, please contact us today!
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