The Danger of Over-Leveraging in Real Estate Investments
Leveraging is one of the biggest advantages that real estate investors have at their disposal.
In fact, real estate investing is designed with leveraging in mind. It helps first-time investors get started in real estate investing when there’s little money from the get-go, and is a keen way to multiply initial investment capital to help build long-term wealth.
When leverage works the way it should, it can significantly boost returns, and help you gain equity a lot faster so that you can turn around and continue investing in other properties. It can afford you with appreciation on 100% of the property’s value while others pay it off so you can accumulate wealth much faster.
But over-leveraging is dangerous, and can put your entire financial profile at risk.
While debt can significantly multiply your reward, it can also just as easily multiply your risk.
Owing too much in a specific property compared to what it’s actually worth and the income it’s generating can put you in a negative leverage and equity position.
Negative leverage occurs when the return portion of the investment property is less than the interest rate on the loan.
Of course, it’s expected that real estate values will fluctuate over time. But if you’re teetering on the edge of profit versus loss based on the amount of leverage you’re holding, it could spell disaster. Any significant change in the value of your property at any given time can have a major impact on your investment.
When values drop or when interest rates increase on your debt, your equity will inevitably decline. Depending on how much you owe versus what you own, you could wind up with no equity – or negative equity.
If you invest in commercial real estate, your loan will generally last between 3 to 5 years. That means you haven’t got much time to play with when it comes to paying down the principal portion unless any returns are put back into the loan. With limited equity on the property, lenders will likely refinance the loan at a higher interest rate, making it even more expensive to hold the investment property.
And let’s not forget about all the other expenses that could pop up unexpectedly, including vacancies, repairs, and other factors that could affect your profits.
Over-leveraging to invest in a property that has no immediate returns or exit is quite frankly a bad idea. If the property is not yet rented, or there’s no immediate buyer lined up, over-leveraging is simply like walking the plank, especially if you’ve got no reserves to cover you.
Let’s say you’ve purchased a property for $500,000 with a $25,000 downpayment. If the value of the property declines by 30%, it’s now worth just $350,000, but you’re still stuck paying interest and principal on the full $475,000 loan. And if the amount that you collect in rent drops too, you could be at great risk of defaulting on the property.
If you were using the cash flow from that investment property to pay off your loan on other investment properties, you could wind up with a whole investment portfolio in foreclosure just because of one bad, over-leveraged loan and a lack of reserve capital to back you up.
How Much Leverage Should You Use?
Before you agree to a loan to make a purchase on an investment property, you’ll need to decide what would be a safe area to stay in when it comes to using leverage to boost returns and avoid being upside down on your loan. Here are a few considerations to keep in mind.
Don’t bet on steep rises in appreciation. Lots of real estate investors have lost a ton of capital because they assumed that recent history would repeat itself. Even if property values in the area have been appreciating at a 15% rate over the past few years, for example, it doesn’t mean this trend will continue into the near future. Betting on this is risky business, and can lead you to buy at higher prices and borrow more than what the property may realistically bring in for you.
Put in a hefty downpayment. The higher the down payment you put forth, the less your outstanding principal will be. Sure, you can put as little as 3% down on a real estate loan, but this leveraging will likely run you into trouble if the income that your investment property generates is close to the interest rate you’re paying on your loan. If the market happens to soften at some point, or you experience a higher vacancy rate than you anticipated, you could find it impossible to carry the loan for the property.
Meticulously – and realistically – calculate your cash flow. One of the biggest mistakes you can make when it comes to real estate investing is overestimating your cash flow and being naive about the financial fallbacks that could realistically creep up and affect your returns. Make sure you’ve accounted for every dollar and every possibility when calculating your cash flow. If the margin between rental income and mortgage costs and expenses is slim, you’re putting yourself at risk.
Keep your long-term investment goals clear. Understanding where you’d like to be in 5, 10 or even 20 years will help you decide how much you should leverage to buy a property. Not only should you be looking at the real returns of a property, you should also think about whether you’ll be using those returns to put back in the property to pay down the principal, or turn around and purchase another property.
The Bottom Line
Levering is obviously a necessity when it comes to investing in real estate and reaping the most rewards for the initial dollars invested. In fact, it’s leveraging that allows massive profits from real estate investments to be made.
But using it prudently and avoiding huge loan ratios that your current financial situation cannot support is critical. While leverage is a tool that can help you realize significant returns, it’s got to be used with a good dose of skill and expertise in order for you to avoid losing your shirt.