How Leverage (The Use of Financing) Affects
Real Estate Investments

Leverage (the use of financing) is probably the most misunderstood factor of real estate financing, and its understanding is a prerequisite to the application of how to effectively use financing in creating, maximizing and retaining wealth through real estate investment. When used properly it can significantly increase the yield on cash invested.

While it is often thought that leverage and risk go hand in hand, and that the greater the leverage, the greater the risk, this is quite often not the case. In fact, once you realize just how leverage works, you will see that if leverage has been used to its maximum benefit, the greater the leverage the lower the risk. Equating leverage with high risk is simply a myth of real estate investment and financing.

What is Leverage & Why Use Leverage?

Leverage is the result of borrowing money at a constant rate lower than the net operating income generated by the investment property. (The constant payment includes both interest and principal, and reflects the payment in relation to the original amount of the principal owed. The constant rate is a function of time and interest and as one changes the constant rate changes.) When the net operating income of an investment property exceeds the constant payment, leverage has been introduced, and the interest yield on the invested capital will now exceed the yield on an all cash investment. The investor is now making money on borrowed money (hence, the concept and definition of leverage).

Leverage can also be applied even if the property is not income producing but is going up in value at an established rate. However, in general, leverage works best when income from the property is generated.

That is why investors (including institutional & professional investors with seemingly limitless available cash for all cash purchases if desired) strategically use borrowed money (leverage) when the marketplace, investment goals and numerous other input considerations make this both a prudent and risk adverse decision. Paying all cash for an investment property, even if able, often times is not the right strategic investment decision.

What Role Does Risk Play in the Use of Leverage?

First of all, some level of risk is present in all investments. Any real estate investment can fail to achieve its projected end result. This does not mean the real estate investment either fails 100% or succeeds 100%. This is true of all types of investments. The level of risk is important to both the buyer and lender (often the seller as well). The buyer looks at the level of risk to mean at what jeopardy he or she has placed the invested capital. The lender looks at the level of risk in the repayment of the loan.

However, as attractive as high leverage is, maximum leverage is only prudent when consistent with overall investment goals and within an investor's ability in keeping the financial obligation under control. The pitfall of leverage is overextension. In the case of income properties this occurs when the net operating income of the property cannot service the loan payment. The causes can be many including: escalating vacancy rates, higher than projected expenses, variable loan rate increases, etc. Proper planning with the assistance of real estate, financial planning, mortgage lending, tax, and legal professionals is advised.

The Key Factors in Real Estate Leverage

• The structure of financing will affect the amount of leverage you receive. The goals of the investor form the basis and level of leverage to be utilized.

• Leverage calculations are only a tool to compare yield calculations between different financing alternatives. The amount of yield should not be the sole basis when evaluating and selecting a loan program.

• Maximum leverage may not always be possible or advisable. The lender or lenders evaluate many factors when determining the loan amount. The goal(s) of the seller (often the source of secondary financing and high leverage) will have an impact on the amount of leverage available to an investor.

• The amount of leverage you could generate through financing is not the only or final criteria. A thorough evaluation of any real estate investment should be completed through a comprehensive due diligence process (analyzing many factors) before a final investment decision is made.

• The ability to effectively leverage your invested capital is greater in real estate investing than most any other investment. This is primarily due to the ease and acceptability of using real estate as collateral for mortgage financing. Real estate has proven itself in the United States as the single most secure form of security for a loan.

• Leverage is a function of financing and is often the gauge of what you are doing. Understanding financing means understanding what happens when mortgages are paid down and equity is built up. Many multimillionaires are people who owe millions of dollars!

The Final Element: How Does Leverage Affect the Increase of Value in Real Estate?

There are six reasons property values go up. Often more than one of these six factors is working at the same time, some in a positive way, others negative. Each of the following six factors can be enhanced or detracted from by the total effect of financing.

The following six factors cause property values to go up:

1. Inflation. Inflation increases the monetary value of property due to both the general decline of the buying power of money (increase in the cost of living) and the proven historical correlation that real estate investment returns have exceeded the increase in the cost of living. This positive correlation is desirable because it indicates real estate is a hedge on inflation.

2. Improved Infrastructure. Community issues such as new roads, bridges, hospitals, water systems, schools and so on all contribute to the infrastructure within a given area. Each can have an impact on property values.

3. Economic Conversion. This occurs when there is a change in the use of a property. Voluntary economic conversion (apartments to condominiums for example) is the best immediate real estate investment strategy available to investors.

4. Increased Cash Flow. The value of every income-producing property is affected by changes in cash flow. The fact that cash flow sets the cash on cash yield (the return on your actual cash investment); anything that increases cash flow will generally increase the value of a property.

5. Capital Improvements. While not all capital improvements increase property values immediately, most real estate investors find that any capital improvement that positively impacts one of the previously mentioned value factors will increase value.

6. Supply and Demand. When the demand for a given property or property type exceeds the supply an increase in value is imminent. The other side of the equation is also true. This is an area where savvy investing and experience comes in handy.