If you’re thinking about multifamily real estate investment, you’ll want to clarify which financing strategies will help you optimize your rental income returns. In the following article, Travis Cadman discusses real estate leverage and how it can help you achieve your ROI objectives. Travis Cadman is the co-founder and CEO of the real estate investment firm, Investar USA.
Unless you have inexhaustible monetary resources (and if that’s the case, why bother investing?), you are going to have to finance your multifamily real estate property. While paying off any debt you accrue may seem like an obvious goal, you may discover that using leverage to acquire more property may offer you a greater return.
But what is leverage, anyway?
The term leverage in real estate means the amount of money you’ve borrowed to purchase a property against the value of the property itself. The term leverage comes from the idea that a real estate investor is using borrowed money to increase ROI on real estate property.
Here’s an example of how an investor can use leverage to increase investment gains:
An investor wants to purchase a $500,000 property. That investor is approved for a $400,000 mortgage, and uses $100,000 of her own money as a down payment. The property value increases by 7 percent in the next 12 months, and by the end of the year, the property is worth $535,000 – a net gain of $35,000.
However, if property values decline, then the investor would have lost $35,000.
While leverage can be an excellent tool for maximizing ROI, it can be quite risky if improperly applied. Here are a few things to avoid when using leverage as an investment tool.
Relying upon consistently high appreciation.
If you’ve experienced annual property appreciation of 10 percent and higher for several consecutive years, it can be very tempting to believe that that’s the new normal. When you anticipate future levels of appreciation to be consistent with the high levels you’ve experienced in the past, you can begin to overpay for properties in the misguided belief that you can recoup the amount at sale.
Good financing causing bad buys.
High leverage financing doesn’t automatically mean that the investment will yield satisfactory returns. Performing due diligence with regard to finding the right and most potentially profitable real estate asset is always more important than simply having a low upfront cash obligation.
Letting property value be your only guide.
When investing in multifamily rental property, the most important consideration is cash flow. While property appreciation may tempt you to leverage up to purchase additional assets, if there is an economic downturn that makes it difficult for you to fill vacancies and you find yourself with outstanding debt and assets in decline.
Ultimately, the cost to borrow is fairly low, so if you have high-value properties, stable tenants that give you steady cash flow, and rental income that pays your monthly mortgage, you may be in a safe position to leverage up additional properties.
Travis Cadman is a real estate investor with over 30 years experience in residential real estate.