Most real estate investment strategies allow the use of leverage through borrowing — earning returns while using someone else’s money.
The simple definition of leverage is “using debt to increase your returns.” Borrowing money to finance projects enables investors to acquire more assets than they could otherwise afford, and to earn outsized returns proportional to equity invested.
The name is pretty self-explanatory: leverage is a force multiplier that can substantially improve investor returns.
Let’s explore just a few of the basic benefits that leverage provides to real estate investors.
1. Enhanced Cash Yield
Investors can generate better cash flow via someone else’s money.
Assume an investor has $200,000 to invest into a real estate project. If a $1 million property is purchased at an 80% loan-to-value ratio, the investor puts $200,000 down and finances the rest at a 3.5% interest rate on a 30-year mortgage.
Suppose that property produces annual net operating income of $65,000.
The investor will be on the hook for loan payments of $43,000 per year ($800,000 loan amount, 3.5% interest rate, 30-year mortgage), leaving them with total cash flow of $22,000 ($65,000 in net operating income minus loan payments of $43,000).
This results in a cash-on-cash return of 11% ($22,000 in cash flow divided by $200,000 of invested capital).
If the investor had to come up with a full $1 million to purchase the property unleveraged, the cash-on-cash return would have only been 6.5% ($65,000 in net operating income divided by $1 million in invested capital).
The additional return is the borrower’s reward for taking on the risk of debt.
2. Better Return on Equity
Leveraged real estate investors can use debt to amplify the returns from appreciation and debt paydown.
In our example above, if the property appreciates by 3% from $1,000,000 to $1,030,000, the unlevered investor earns a 3% return from appreciation ($30,000 in appreciation divided by $1 million of invested capital).
However, the investor that borrows 80% of the purchase price earns a 15% return from appreciation ($30,000 in appreciation divided by $200,000 of invested capital).
Additionally, of the leveraged investor’s $43,000 in loan payments, $28,000 will have gone towards interest, but the other $15,000 will have gone towards principal in the first year. This $15,000 in equity from loan payments goes to the pocket of the leveraged investor.
So, the leveraged investor made $45,000 in year one from appreciation and loan payments, while the unleveraged investor made only $30,000 from only appreciation.
3. More Favorable Tax Treatment
Leveraged investors can depreciate the entire value of the property, despite the fact that they financed most of it — which can result in very sizable tax deductions.
If the investor purchases the $1 million property in 100% equity and depreciates the property over 27.5 years, the investor will be able to recognize depreciation expense equal to 3.6% of its invested capital ($36,000 in depreciation divided by $1 million in invested capital).
If the investor finances 80% of the purchase price, that investor will still be able to recognize $36,000 of depreciation expense; for this investor, though, this amount is equal to 18% of its invested capital in a given year.
The leveraged investor will be able to deduct $28,000 in interest expense on the mortgage, for an additional 14% of invested capital being expensed.
In total, the leveraged investor will have deductible expenses of 32% of invested capital, while the 100% equity investor will have deductible expenses of only 3.6% of invested capital.
This is a humongous difference, and investors are wise not to overlook it.
To recap, in our illustration of the leveraged investor vs. the unleveraged investor, here are the differences in outcomes:
There’s just one problem with leverage: it comes with risk. Taking on debt demands heightened research and analysis to ensure investors find a loan that meets their needs and doesn’t expose their financials to an unhealthy level of risk.
Many loans require personal guarantees from principals or have onerous hidden covenants that can put too much power in the hands of a lender. There’s no substitute for shopping around, and one investor’s ideal loan may look very different from another’s, but there’s still a few common attributes to look for.
Prudent real estate investors should think long and hard about their risk tolerance before utilizing leverage -- but, when properly utilized, debt can produce compelling outcomes.