How Using Leverage Can Benefit Real Estate Investors
By Anthony Cazazian, EVP and Head of Origination, B2R Finance
While many residential real estate investors buy in cash — nearly 32% — many have discovered the benefits of leverage. What is leverage? According to Investopedia, “Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.”
Here are three reasons real estate investors like leverage:
- It accelerates growth. A residential real estate investor can build a larger portfolio more quickly with leverage than without.
- It typically offers higher returns. The smaller the amount of equity you put in, the higher the return on that equity, so long as the cost of debt doesn’t outweigh the benefits.
- It can provide tax advantages. The most obvious are the mortgage interest expense and asset depreciation deductions.
How much leverage is the right amount?
This is a personal decision. Investors must decide for themselves how much is too much and the decision will ultimately depend on their risk tolerance, investing experience, view of the market and the property they are investing in. Most investors who are willing to utilize debt consider the risk across different ranges of leverage. For example, an investor might consider the following:
- Leverage between 40-59%: Low leverage with ability to withstand severe economic downturns or poor operating performance
- Leverage between 60-69%: Moderate leverage enables growth but assumes good operating performance
- Leverage of 70%+: High leverage with lower capacity to withstand an economic downturn or long periods of poor operating performance
Consider the Following Scenarios
An investor increases LTV from 50% up to, say 75%. At this LTV, the risk to the transaction increases while the margin for error decreases. Though risks can present themselves in a number of ways, often the most obvious risk is related to the property’s value. In a severe downturn, when property values decline, an investor’s 20% or 30% equity may drop or in a worst case scenario, leave him or her with negative equity in the property.
Now consider a real estate investor who has a balloon maturity on a mortgage loan and his or her equity drops below the threshold that would enable them to refinance. Now the investor has entered a workout situation and may even risk losing the investment property.
Finally, consider an investor whose loan is based on the property’s cash flow. Too much leverage will translate into a higher cost of debt, and the amount of cash flow to cover the debt will result in a tighter debt-service-coverage ratio. In this scenario, the real estate investor will have little room for error when it comes to operations. If the investor has unexpected vacancies, declining rents or poor property management, the investor could struggle to service the debt more than if the investor had borrowed with lower leverage.
Recourse vs. Non-Recourse Leverage
The type of leverage a real estate investor chooses also changes the risk profile of the leverage.
If a real estate investor is providing personal recourse, then the investor is subjecting personal assets to guarantee the loan.
The risk profile is different with a non-recourse loan. If an investor stops paying on a non-recourse loan, the only thing at risk is the individual property that secured the loan.
There are advantages and disadvantages to each type of loan that the investor will have to weigh. For example, non-recourse loans generally come with higher rates and more overall requirements since it is a riskier loan from the lender’s perspective.
There are a number of benefits to utilizing leverage when investing in rental properties. It can help an investor expand a portfolio by freeing up his or her cash to invest in other properties. Using leverage could also offer higher return on equity since leverage enables the investor to use less of his or her funds. Finally, it can offer tax advantages through mortgage interest expense and asset depreciation deductions.
That said, there are a number of factors that a residential property investor must consider in order to pick the loan product and leverage amount that best fits his or her investing profile. Due your diligence to find a lender that understands your business and will be a good partner to help you grow.
B2R Finance offers rental investors innovative lending products to help unlock equity from existing portfolios and provide the cash needed to build rental portfolios nationwide. For more information about how B2R can help you obtain rental property financing, just call 800-227-8107 or visit http://www.b2rfinance.com/apply-now and follow us on Twitter @B2RFinance.
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