How to Leverage Borrowed Money in Real Estate
With interest rates and most importantly mortgage rates being so low, more prospective buyers ask me about the use of Leverage to help buy more income property. They've had success in the past and it seems like there is still room for growth and generation of high rental yields.
An example to illustrate the concept of increased acquisitions with increased use of leverage-
An Investor has $100,000 to invest. He can choose to use that $100,000 to buy a house that will produce $1,000 per month in income or $12,000 per year. This equates to a 12 percent return-on-investment or...
Another option- he also could instead use that $100,000 as a 20 percent down payment on FIVE similar homes, each listed at $100,000. With an $80,000 mortgage on each, the cash flow would be approximately $300 each month per house, which is $1,500 per month each or $18,000 per year. This works out to an 18 percent return-on-investment, or 50 percent better than buying just one home.
In addition option 2 allows the investor partake in a larger Reward, but also larger Risk depending on the movement of the Real Estate market. His returns BOTH up and down are magnified.
In the case of buying one property as per option 1, if real estate goes up by 50% in the next 8 years then his investment grows by $50,000 due to capital appreciation, but if real estate shrinks by 50% he loses $50,000.
Now with Option 2 if Real Estate increases by 50% over the next 8 years the investment jumps by $250,000 in that period, however if real estate drops by 50% he loses $250,000, again with leverage his returns both up or down are magnified due to the use of Leverage.
An Investor confident in the trajectory of the real estate market over his investment horizon may want consider the use of increased leverage especially given the number of high quality renters available today.
The use of Leverage needs to be considered very carefully as it does carry greater risks, including, maybe having to carry the mortgage and other payments on multiple properties without the help of renters, which can be cumbersome in addition to dealing with managing or overseeing more units.
However, for the Investor or group of Investor comfortable with the risk associated it can be a great strategy.
Especially for the reasons
Increased Cash Flow & Passive Income - With more properties rented as mentioned in the example, there should be more rent money left over after the mortgage and related expenses have been paid especially with these great low mortgage rates. Increased cash that you did not have to work for, that was produced by your property investments. This increased Cash flow is an added bonus on top of your capital appreciation.
Increased Capital Appreciation - This is the increase in value of the property over time, magnified by the use of increased leverage, as mentioned in our example, though not guaranteed, if the properties are researched and bought properly in stable areas, the property will likely increase in value over the years. This Capital Appreciation is magnified through the use of Leverage.
Tax Efficiency – The best part about an investment property in the opinion of many successful investors, is the tax deferral on the capital appreciation of the property, no matter how much the investment grows in value, you don’t pay tax until you sell the property, in additional once sold the property is in most cases taxed as a capital gain, meaning its only taxed at a fraction of ordinary income.
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Note this is not a recommendation or an endorsement to take any action, all buyers should consult their chosen professionals before making any decision not just myself, their chosen real estate agent, but their tax accountant, lawyer etc..