Investing in real estate is a good way for many people to diversify their portfolios, but it’s sometimes easier said than done.
When you invest in real estate, it’s not necessarily as much of a passive endeavor as people think. Plus, you need capital to make a purchase, and the process of buying can be long. As you can imagine, there are significant risks along the way.
What is Leverage?
Leverage is borrowed capital, meaning debt, to increase your possible returns on investment. Leverage is used by not only individual investors but also companies. Leverage creates an expansion on the returns potential and expands the downside of a risk if something goes wrong.
One of the easiest ways to use leverage is by tapping into your own money. With the example of a mortgage, a 20% down payment will get you 100% of a property where you want to live. There are financing programs that will let you put even less down.
If you buy the house as an investment, you could be in a situation where your partners will put up some or all of the money. Some sellers might also finance part of the purchase price of a property they want to sell so that you can buy a property with little to no money down.
The following is an example:
• The typical real estate purchase often requires a down payment of 20%. If you’re buying a $500,000 property, that’s $100,000.
• When you put down 20% and borrow the rest, you’re using a small percentage of your own money to make the purchase. A lender provides the rest.
• If the property goes up in value at a rate of 5% a year, then your net worth grows to $525,000 in 12 months.
• If you bought the home outright without a loan, for example, when you paid in full for a property at a price of $100,000, assuming the same 5% appreciation rate, the property would go up to $5,000 in 12 months. That’s compared to $25,000 for the more expensive property.
• This creates a $20,000 difference in your net worth.
So what should you avoid when you’re using real estate leverage?
The Risks of Leverage
Leverage can work for you, but it can also work against you.
Going back to the original scenario, if you used $100,000 to make a down payment and the prices in your area went down for several years, you will experience the leverage concept in reverse. Your property might be worth $475,000 in a year rather than $500,000.
If you’d bought the cheaper property outright, you’d lose less than you would on the more expensive home.
If you’re in a market where the prices are falling, you can find yourself in a situation where you owe more than the property’s worth.
Dealing with declining prices can lower or fully eliminate your profits if you're an investor.
Risk #1: Expecting High Appreciation Levels
One scenario that tends to get investors in trouble is thinking that something they experienced before will happen again. The real estate market has been booming in the past few years, but now there’s no expectation it will continue.
The past or even the current situation isn’t necessarily a future predictor.
You might overpay for properties if you’re counting on a historical appreciation rate. You could think you’re going to realize the difference at the sale due to appreciation, but if that’s not the case, you’re holding a loss.
Risk #2: A Payment That’s Too High
You might think it seems like a good idea to have a property with a low down payment. You see a strong return on your investment because you’re putting so little cash down.
The issue is that there are higher payments that come with higher leverage.
The more you borrow, the more your monthly payments will be.
If there’s a dip in the market or you’re experiencing vacancies, you might not be able to keep up with the high mortgage payments.
Risk #3: Underestimating the Importance of Cash Flow
Finally, if your rental income minus the costs of your mortgage and expenses is giving you a good cash return, then even if the property didn’t gain in value, it’s probably going to be okay. If that’s not the case, you’ll find yourself in a difficult financial situation.
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