Learn the benefits (and perils) of putting leverage to work for you with this basic primer
Leverage is an incredibly important part of most real estate transactions. However, as we saw during the catastrophe a decade ago, too much of a good thing can be a recipe for disaster. It’s essential for real estate investors to intimately understand how leverage works, the benefits and shortcomings of using it, and the amount necessary to produce an optimal return.
What exactly is leverage?
In this context, leverage is simply the amount of financing that exists on a property compared to its market value at any given time. In a straightforward real estate deal, a fixed mortgage may represent all leverage involved, but in more complicated transactions, it can include a variety of different debt layers, such as first and second mortgages, some type of mezzanine financing, or capital stack.
The primary benefits of leverage
Real estate investors use leverage as a way to increase the return of an investment and lower capital outlays. It is primarily employed when the debt cost, such as a mortgage, is cheaper for an investor than the unleveraged returns a property can generate. By upping the proportion of financing, buyers can take any additional profit on the deal and apply it to the remaining equity to further boost leveraged returns.
The dangers
In the real estate market, values can change – quickly, in rare circumstances (remember 2006?). When prices are climbing, the amount of leverage in a deal isn’t much of an issue, but as they begin to fall, owners can end up owing more to backers than a property is actually worth. For investors, this can mean the simple inconvenience of reduced profits, or disastrous losses in a market that changes swiftly. And if rents in an area fall as well, investors could be looking at a scenario where they cannot afford to hold a certain property.
Use only the amount of leverage that you can live with
While some home buyers may not think about financing in terms of “leverage,” most are using this basic investment tool to purchase residences. They pay off the value of the home over the course of several decades while enjoying the property, and it gives them access to real estate that would otherwise be unobtainable without bringing significant capital to the table.
In the commercial arena, leverage is a more complex, finely-tuned instrument for improving returns on property holdings. Of course, the risk occurs when property owners borrow too much and if any type of downturn occurs, they will immediately see negative returns on their investment. Striking the balance with the right proportion of leverage is essential in both residential and commercial transactions, but a comprehensive assessment of a commercial deal involves reliably calculating both the income that will be generated from the property’s use (i.e., its rental income) and its conservatively-projected value.
If you’re interested in learning more about the power of leverage, and how to use it sensibly to grow your real estate investment portfolio, reach out to Morris Southeast Group. We are veteran commercial real estate agents who have been serving Miami-Dade, Broward, and Palm Beach counties for decades. Contact our team by phone at 954.474.1776, reach Ken Morris on his cell at 954.240.4400, or email kenmorris@morrissegroup.com.
Tags: commercial property, Leverage
