The True Rockstar of Real Estate Investing: Leveraging


Most people get into real estate investing in order to develop some level of wealth creation. Maybe an average investor isn’t looking to make millions overnight by investing, but they are looking to do something smart with their money still the same. Or, someone may be trying to make millions overnight by investing.

What’s unique about real estate investing is that, while making millions overnight may not be exactly what happens, there is a tremendous ability to generate wealth in much more unique ways than you would be able to via other means.

One of these unique ways is leveraging.

Leveraging means you use someone else’s money, or money borrowed from somewhere else, to help finance a property investment. The most common example of leveraging in real estate is when people buy their primary home with the help of a mortgage. You are borrowing money from someone else (the bank) to purchase your home. You’ve now leveraged your home.

Where leveraging gets a little more intriguing is when you think of leveraging investment properties specifically, as in properties you are buying solely for the financial return aspect, and how you might structure your leveraging strategy in order to maximize those returns.

In order to understand how to structure your leveraging strategy, you first have to know the logistics about what leveraging offers.

Benefits of Leveraging, Part 1

The most basic benefit of leveraging, of course, is that you don’t have to use your own money. This is especially helpful if you don’t have much of your own money to invest but yet you still want to get into the real estate investing game.

The bigger benefit to investing, however, is what it does to the returns on your investment. This is what people tend not to be as clear on.

Keeping the numbers simple, let’s say you buy a rental property for $100,000 that rents for $1,000 per month.

Scenario 1: All-Cash Purchase

You purchase the property in all cash. After paying property taxes and insurance and miscellaneous expenses each month, you take home $700 per month of that $1,000.

Scenario 2: Leveraged Purchase

You finance the property with a conventional mortgage, putting 20% down which equals $20,000. You have the same expenses per month as with the all-cash purchase but now you also have to pay the mortgage payment each month which, at a 5% interest rate, equals about $430 per month. Now instead of taking home $700 per month as with the all-cash purchase, you now take home $270 per month after all expenses.

At first glance, it seems like you make more money with the all-cash purchase because you are taking home $700 per month rather than $270 per month, which is a notable difference. But here’s what matters in real estate investing. You want know how much money you are making on the money you invest. How this is determined is via the cash-on-cash equation. How much “cash” are you making in relation to how much “cash” you put in?

This number is determined by dividing the annual net income by the amount of money you put in.

Scenario 1: All-Cash Purchase

(Net monthly income x 12 months)/cash put in = ($700 x 12)/$100,000 = 0.084 = 8.4%

= 8.4% cash-on-cash return

Scenario 2: Leveraged Purchase

(Net monthly income x 12 months)/cash put in = ($270 x 12)/$20,000 = 0.162 = 16.2%

= 16.2% cash-on-cash return

Whoa. Do you see that? The leveraged purchase provides literally double the return on the money you invested. While that monthly cash flow seemed significantly lower initially, you’re actually getting double the bang for your buck. Because look at those equations—look at the difference in how much of your own money you’re putting into each scenario. That’s a more significant difference than the difference between those two cash flows. That’s where the difference lies.

The result won’t always be that a leveraged property will offer double the return on your money that a property purchased with all cash will provide. In fact, depending on the numbers, it can actually turn out that the leveraged returns end up negative while the non-leveraged returns remain positive. It’s all about the numbers on each individual property and the financing terms.

Benefits of Leveraging, Part 2

So you’ve doubled the return on your money by leveraging. Congratulations. But the fun isn’t over yet.

If you look at all the numbers above, and think slightly outside the box, there may be another benefit staring you in the face.

In the all-cash scenario, you spent $100,000 of your own money. That suggests you have $100,000 of your own money to invest. But in the leveraging scenario, you only had to spend $20,000 of your investable money. If you look at $20,000 compared to $100,000, there are actually five $20,000s you could invest.

So instead of buying one property for cash for $100,000, you’re now able to buy five because you can spend $20,000 five times and that equals your $100,000 investable cash.

With $100,000 total cash to invest, you can either pay all-cash for one property in Scenario 1 or you can finance five properties with Scenario 2.

What are the benefits then, aside from a better cash-on-cash return, with the financing scenario over the all-cash scenario?

  • Higher total monthly cash flow: $1,350 vs. $700
  • 5x the tax benefits (which are huge)
  • 5x the appreciation benefits (when applicable)
  • Diversification; all your eggs aren’t in one basket in case you pick a lemon property
  • Offset against vacancy and repairs; if the tenants in one house move out, you have to cover vacancy and repair expenses out of pocket. If the tenants in one house move out but you own five houses, you can use the income from the other four houses to offset those expenses so you don’t have to come out of pocket for them.

Let’s expand just on the appreciation benefits mentioned to give you a clearer perspective of the advantage of having more properties. If a house appreciates, that’s basically free money to you. So if a $100,000 appreciates $30,000, you gain $30,000 of essentially free money. So on your all-cash purchase property, if it gains $30,000 in appreciation, you’ve gotten a bonus $30,000 in your pocket. But if you own five properties and they all gain the same $30,000 in appreciation, you’ve now gotten a bonus of $150,000 in your pocket—5x the $30,000. That’s $120,000 more than you would have if you had bought the property for all-cash.

Tax benefits are less intuitive to calculate, but they are substantial on rental properties. So you’re now making more money per month, you’re making substantially more in appreciation (a.k.a. free money), your tax benefits are higher than what they would be on just one property, and if a property is bad it isn’t a total wash because it can be offset by the other properties, as can the vacancy and repair expenses.

Note: Numbers being used are solely to illustrate the math and are not actual numbers. All equations should be run off actual property numbers and never estimated. Also, $100,000 buying five properties does not take into consideration closing costs with the lender and other expenses to buy the property.

With all of those benefits though, what’s the catch? Why isn’t everyone leveraging everything they can?

Leveraging vs. All-Cash: The Debate

Isn’t it obvious leveraging wins out over paying all-cash for an investment property? Well you’d think so just based on the benefits of what it can do for your financial gain, but the reality is that there are a lot of people shouting from the rooftops that leveraging is dangerous and risky and should be avoided at all costs.

So what’s the problem with it? Fear.

People fear leveraging. Specifically they fear:

  • The risk of not being able to cover the mortgage payment each month for any reason, which could by chance lead to foreclosure
  • The bank being in control of their asset
  • Becoming overleveraged—the leveraging and consequential payments owed become greater than what can be managed
  • The interest rates on the loan rising
  • Assumed appreciation not happening and leaving them unable to pay the loan

Coming in a close second to fear is Control. Oftentimes people feel better when they don’t put their money or efforts, or properties, into other people’s hands.

But going back to the fear component; the reality is that very often the fear surrounding leveraging is the unknowing of the realistic logistics around it. Taking the list of possible fears, here are the easy and practical mitigations:

  • The risk of not being able to cover the mortgage payment each month for any reason, which could by chance lead to foreclosure

This is why always having a nest egg is important. As mentioned earlier, another helpful remedy is to own more than one cash-flowing property so the expenses of one may offset another. Or, if you initially had $100,000 of investable cash, you’d be wise to set some of that aside for just this emergency scenario.

  • The bank being in control of their asset

Technically the bank can take your property but legally they can only do that if you don’t make the payments set in the contract. Otherwise, a bank will do nothing to your property and you are legally in control of your property. Plus, one could argue that even if you pay for the property in full that you still aren’t in 100% of control because you still owe property taxes and if you don’t pay those, your property can be taken. Same thing as with a mortgage.

  • Becoming over-leveraged—the leveraging and consequential payments owed become greater than what can be managed

The benefits of leveraging do not negate the advisement to be smart about your leveraging. Going buck wild and getting a million loans and having no idea or plan as to how they will be supported would be highly irresponsible. The key is to know what properties you are buying and how those will support the loans, and again, always have a nest egg.

  • The interest rates on the loan rising

This is only a danger on adjustable-rate loans. Fixed loans should always be used for this exact reason. Loans with balloon payments pose the same risk

  • Assumed appreciation not happening and leaving them unable to pay the loan

This is why monthly cash flow on a property is crucial and/or if your property doesn’t cash flow, you should have a plan in place as to how to cover the loan every single month as well as a backup fund for it.

One argument against leveraging being risky is that, if you really dig into and look at the actual consequences of going belly-up on a loan, the magnitude of disaster is really limited to you foreclosing on the property. That is the worst-case scenario of not being able to keep up with the mortgage/loan—you lose the property. If you lose the property, literally the only things you lose are your initial $20,000 down payment and your credit score.

The main argument for paying all cash for a property is that if you aren’t reliant on a loan, none of these things are at risk. Well, maybe, but should anything go belly-up with your property then you have your whole $100,000 of personal money tied to that property. Whereas with leveraging, the bank is the one with their money in the pot; it’s not your money. So maybe you lose $20,000 and your credit score that you wouldn’t have otherwise lost, but that seems like a small price to pay as compared to all of the benefits you stand to gain from the leveraging play…

The debate between paying cash for a property versus leveraging a property is infamous and will likely never be resolved. One reason is that there really isn’t a right or wrong answer. Both methods can offer you financial gain via your real estate investment when you buy a solid property. Some situations may favor paying cash versus financing or vice versa; every situation is different. The other reason the debate will likely never be resolved is psychology. Some people, no matter how accurate the numbers are that support leveraging as being the advantageous move, will just lose sleep at night knowing they have loans out on their properties. And no investment, no matter how good of an investment it is, is worth losing sleep over.

Real Estate Investing Can Be Simple.
Let Us Show You How.

From Rookie
to Expert

Let’s kickstart your investing journey with a free beginner’s guide: 7 Rookie Real Estate Investing Mistakes & How to Avoid Them!

    *By entering your information, you agree to join Hipster's mailing list. You also agree to our Disclosures. Unsubscribe at anytime with just a click.