Real estate is one of the most powerful investment vehicles that encourages using debt. While people might raise eyebrows to you buying stocks on the margin, they probably won’t think much of you using debt on real estate.
After all, the mortgage and mortgage-backed-securities market is one of the biggest sectors in the financial world. Homeowners and investors are no strangers to debt. But why would someone want to leverage their property in the first place?
The answer lies in the returns.
Cash vs. Leveraged Returns
Let’s say you have $100,000 in cash that you would like to invest. You find a piece of real estate that would make a nice rental property, and you get it under contract for a $100,000 sales price.
You can decide to buy the property in all cash. You pour all your available cash into it, so you do not have any debt on the property. After a year, the property appreciates $10,000. You also bring in $5,000 in rental cash flow. If you sell the property, you will walk away with a solid 15% return
Take that same $100,000 property, but now assume you used an $80,000 mortgage to buy it. You used $20,000 in cash to buy it. Let’s assume that the property doesn’t even cash flow; all the rent is used to pay the mortgage and expenses and there is nothing left over. Now when the property appreciates by $10,000, even with no cash flow, you just made a 50% return. You also still have $80,000 of your cash left over since you only invested $20,000.
On top of that, with a leveraged property, the rent coming in will be used to pay down the mortgage balance over time. And because the loan is not your money, you are practically getting something out of nothing. You have purchased the revenue stream (the property) using a loan, and the revenue stream is used to pay down the loan. You keep the revenue stream once the loan is paid off. And you only have to pay a fraction of the cost up front.
Multiplying Your Reach
By using debt, you can buy more properties than if you were just using cash.
Using the example from above, you can buy five $100,000 properties using 20% down mortgages or just one of those properties using all cash. You could also buy a $500,000 property with a $400,000 mortgage using your same initial cash up front.
Every dollar you have could theoretically be used to buy $4 or $5 in real estate. When your mortgages are paid off, well, that’s a lot of real estate…
If you are looking to build wealth quickly, debt is likely going to be a very important tool. Cash is comparatively slow. But debt can be dangerous.
Risks
Using leverage is not without risk. Using debt for investing closely follows a risk versus reward trade off. The more debt you use, the higher your potential returns but the higher your risk of default. Similarly, the less debt you use, the lower your maximum returns but the lower your risk.
It goes without saying that some debt is bad debt. Bad debt is debt that has too high of an interest rate to be used profitably or debt used on non-performing assets that do not produce you a return. Bad debt is high risk, low reward.
The best real estate investors use a healthy balance of debt and equity over the long-haul. They do not become over-leveraged. They take measured risks, understanding the costs associated with a potential default. They also keep cash on hand in the event that they need to cover payments in an emergency.
If you are unsure about what strategy works best for your goals, consult with a licensed financial professional. Your risk tolerance is critical to determining your optimal financial strategy.
Conclusion
Using debt to purchase real estate is a powerful way to multiply your return on investment. However, it is not without risks.
Leverage and real estate are part of a delicate balancing act. It can be easy to over-leverage. But, when used properly, leverage can greatly increase your return on investment and catapult you towards your financial goals.