What does leverage in real estate mean?
Leverage in real estate simply means how much money you borrow to finance an investment property compared to the property’s worth. You are “leveraging” other people’s money to maximize your ability to buy more investment properties with less. The higher your leverage, the higher your potential return on investment (ROI).
Loan to Value Ratio
When calculating leverage power for a rental property, divide the investment property financing amount by the appraised property value to determine the loan-to-value ratio.
On a $900,000 property with a 20% down payment ($180,000) the calculation would look like this:
$720,000 loan ÷ $900,000 appraised value= 80% loan to value
Remember that this calculation is done on appraised value, not what you paid or are paying to purchase a property. If a property appraises for more than the purchase price this is a bonus, which will result in a beneficial lower loan to value ratio.
Conventional mortgage lenders often provide better loan terms to borrowers who have loan-to-value ratios no higher than 80%. While there are other forms of financing when purchasing an investment property, a 20% down payment could save some money on the mortgage payment.
Some real estate investors look for bank owned or short sale properties. If a property can be obtained below its appraised value, there is instant equity in the purchase and a lower loan to value ratio.
Doing the Leveraging Math
Assuming you make a real estate purchase with a 20% down payment – or $180,000 on a $900,000 asset. This uses a relatively small percentage of your own funds to make the purchase, with the majority provided by a lender. Real estate investors often refer to this 80% as “other people’s money.”
Assuming the property appreciates at 5% per year, the borrower’s net worth from this purchase would grow to $945,000 in just 12 months.
When we compare this gain to purchasing a property outright with no loan, the value of leveraging becomes clear. Take that same $180,000 cash out of pocket and purchase a property outright. Assuming the same 5% rate of appreciation, the investor’s net worth would be $189,000.
Even though real estate markets go up and down, over time, the use of leverage can have a significant, positive impact on your net worth.
Leveraging does come with risk. Keep real estate’s most basic rule of thumb in mind: A property is only worth as much as someone is willing to pay. Add to that what the bank thinks the property is worth via an appraisal. Property value is not based on how much you’ve put into fixing it up or what you think its worth.
The best time to buy investment property is when rents and property values are rising, which is an easy thing to check online or with an agent. Under favorable market conditions, a fixed rate mortgage means payment on the investment property remains the same as income and value on the property continues to rise. Real estate values are still appreciating which creates a good environment for investing.
In real estate markets where prices fall significantly, homeowners can end up owing more money on the house than the house is actually worth. Declining prices and rents can not only eliminate profits, it could mean a property cannot be rented at a price that will cover the cost of the mortgage and other expenses.
Consider real estate as a long-term investment to help lessen the risk, balancing out fluctuations in the real estate market over time.
Options for Financing a Rental Property Investment
Taking out a loan for an investment property incurs interest, and in most cases, closing costs- things to keep in mind in your budget. Here are three common types of investment property financing for a rental property:
Traditional Home Mortgage
The most common way to purchase an investment property is almost exactly the same as buying a house you are going to live in, with one exception. The stated purpose for the loan is for an investment property rather than an owner-occupied home. However, mortgage rates in rental investment property financing are sometimes higher, require larger down payments, and have different approval requirements than properties occupied by their owners.
You may be able to use the rental income of your current investment property to qualify for a new investment property loan. You must be able to document that you have owned the investment property for at least two years. Be ready to provide financial statements and copies of existing leases. The income from your investment property should be reflected on your tax returns, which you may need to provide to the lender.
Home Equity Line of Credit
Another way to purchase investor real estate is to use the equity in your current home to get a loan for the down payment on a rental property. This requires no (or very little) out of pocket money for your investment purchase. A HELOC (Home Equity Line Of Credit) is a line of credit secured by the equity in the house you live. Interest rates and payments are lower than a traditional mortgage.
Special Loan Programs
Government sponsored Federal National Mortgage Association, more commonly known as Fannie Mae, has favorable low interest, low down payment loans for investors that do not require mortgage insurance. These are usually for homes that were not sold through traditional marketing and are now being sold by Fannie Mae at auction. You can check available Maui County properties here.
Favorable Time for Financing
Interest rates are low, meaning it is good timing for the financing investor real estate. However, evaluate that you have chosen a good location and do the math to ensure you have positive monthly cash flow, can afford dips in the market, have potential for equity appreciation, and enough demand for solid tenants.
Your monthly cash-flow and what you do with it
If the positive cash-flow covers all expenses, you have quite a few options. You can use the excess to cover your living expenses, pay down debt on an equity line or other credit. It really depends on your long and short term objectives.
Perhaps you want to pay off the mortgage as quickly as possible and supplement your retirement with rental income. Maybe you want to save up toward the down payment of your next investment. Another option is to split profits between paying down credit, keeping some for living expenses and saving for the next investment.
There are many rental related expenses that investment property owners can deduct. However, tax laws have changed, and some items that were deductible are no longer eligible. Check with your tax professional for more information on all the tax benefits of real estate investing.
Part of the joy many find through investing in real estate is making a profit using other people’s money. Destination Maui Realty can help you secure an investment property, and manage it after the purchase. Helping to keep a property maintained and rented will increase your equity building potential.