The seesaw swings both ways with leverage
Unlike other forms of investment, real estate investing affords property investors the innate ability to leverage their assets to obtain much greater returns over time. While this is a tried and true investing fundamental when purchasing real estate, there are also pitfalls one must be aware of before jumping headlong into the property acquisition process and obtaining any investment mortgage loan. To better protect yourself, here are the main pros and cons you’ll need to be very cognizant of when using leverage as you invest in rental property and take out investment property loans.
The main advantage of leverage
When utilizing leverage, the property investor is trying to use as little of their own investment dollars to act as a springboard to greater wealth. Return on investment (ROI) is traditionally much greater utilizing leverage than when only using one’s own investment dollars to fund your projects. By obtaining a rental mortgage on one or all of your investment properties, you’re able to leverage the most amount of investment dollars while keeping the absolute amount of your own dollars sunk into investing to a minimum.
As an example, if a $100,000 rental property acquisition cost has a down payment of 30%, then you need only put up $30,000 of your own funds to lock up the property. If market appreciation is 4% a year, the property value in this example would increase to $104,000 on the rental real estate. But your ROI on it would be 13.3% ($4,000/30,000). And as you continue to grow your business, slowly adding properties, you can take out mortgages on each one, eventually using the equity in each prior one to help defray your new acquisition down payment costs.
The main drawback of using leverage
Traditionally, home values have remained quite stable over time. However, in periods of great flux or recession, they can decrease in value. And if you need to get out of the market at any given time, this can create a dangerous scenario for real estate investors. If, using the example from above, the $100,000 property decreases in value by the same 4% in a given year, the property would be worth only $96,000. And you, the property investor, still need to make interest and principal payments on the loaned amount (in this case, $70,000), regardless of the current market valuation. If you have leverage multiple properties, and we hit a bad real estate market all of a sudden, well…you can see the potential for financial destruction that could ensue.
Beware the dangerous housing “bubbles”
Luckily, these periods of “correction” or housing bubbles come few and far between. But nevertheless, it is imperative when buying rental property that any prospective property investor understand the conceptual financial risks inherent when taking on investment property mortgages, thereby increasing their leverage. While leverage is one of the fundamentals of real estate investing, if you’re willing to take moderate risks, you’ll be able to manage using leverage to your advantage. However, always weigh the illiquidity of property investments, as well as the lack of diversification if you only acquire properties in, say, residential real estate and/or in one geographic area.
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