Your Questions About Leverage, Answered

Leverage is vital for those looking to grow their real estate portfolios.  But the concept itself can leave some scratching their heads.  Let’s answer a few FAQs, shall we? 

Q: What is leverage? 

A: Leverage is a technique in which investors use borrowed money to purchase real estate and subsequently amplify their returns. This borrowed money often comes from a bank, but that’s not always the case.  Leverage can also come from credit unions, hard money lenders, and private money lenders. 

This loan is then used to cover a portion of the property’s price.  The most common loan is a mortgage, which allows an investor to pay in installments that they can afford, while still owning the property. 

Because investors typically measure the return on the cash they invested, leverage generates higher profit margins than if the property was purchased entirely with cash.  (More on this soon.)  That said, leverage is also associated with a higher risk of defaults and/or bankruptcy. 

Q: Ok, so how is it calculated? 

A: In real estate investing, leverage is determined by the loan to value (LTV) ratio. To determine this ratio, the lender will compare the financing amount needed against the property’s value.  This ratio helps lenders determine risk on their end (and investors should look at this too). The lender also looks at the expected revenue and the investor’s credit to determine the loan amount—and the interest rate.  Dividing the loan amount by the value of the real estate gives you the LTV ratio.

Q: What are the risks surrounding leverage? 

A: Leverage does not come without risk. By foregoing an all-cash investment, the investor pays the loan off by slowly chipping away at it each month. Missing a payment could lead to harsh penalties like exorbitant fees, losing ownership, or even bankruptcy.

Q: Why are profit margins higher when you utilize leverage?

A: This is best answered by crunching the numbers:

First, let’s discuss the purchase of a five-unit rental property with 70% LTV:

  • Purchase Price: $1,000,000
  • Debt: $700,000
  • Equity: $300,000
  • Annual Debt Service: $50,000
  • Sale Price after 1 Year:  $1,100,000
  • Profit:  $50,000 ($1,100,000-$1,000,000 purchase price-$50,000 debt service)

Return on Equity:  16.6% ($50,000/$300,000)

Then, let’s compare the first example with the purchase of a five-unit rental property with 100% cash:

  • Purchase Price: $1,000,000
  • Debt: $0
  • Equity: $1,000,000
  • Annual Debt Service: $0
  • Sale Price after 1 Year:  $1,100,000
  • Profit: $100,000 ($1,100,000-$1,000,000 purchase price-$0 debt service)

Return on Equity: 10% ($100,000/$1,000,000)

Although the leveraged investment saw a 6.6% increase in return on equity, it is important to note that it is riskier than the all-cash option. Why?  There are many factors that play into whether a leveraged investment will be successful or not. For instance, let’s look at the same stats, but this time the property is depreciating in value. 

Purchase of a five-unit rental property with 70% LTV:

  • Purchase Price:  $1,000,000
  • Debt: $700,000
  • Equity: $300,000
  • Annual Debt Service: $50,000
  • Sale Price after 1 Year:  $900,000
  • Loss:  -$150,000 ($900,000-$1,000,000 purchase price-$50,000 debt service)

Return on Equity:  -50% ($-150,000/$300,000)

Purchase of a five-unit rental property with 100%  cash:

  • Purchase Price:  $1,000,000
  • Debt: $0
  • Equity: $1,000,000
  • Annual Debt Service: $0
  • Sale Price after 1 Year:  $900,000
  • Profit:  -$100,000 ($900,000-$1,000,000 purchase price-$0 debt service)

Return on Equity:  -10% (-$100,000/$1,000,000)

As you can see, that is a significant difference in returns.  An all-cash investment can help to safeguard against losses, but it will also see a smaller ROI.  To determine which is best for you and your investment strategy, it is important to weigh risk versus reward and decide what ratio you are personally comfortable with. 

Q: What about operating leverage? 

A: In addition to financial leverage, operating leverage is often used in real estate as well.  This is created by the large number of fixed costs required to operate the business (salaries, taxes, utilities, maintenance, debt service, etc.).  

Operating leverage measures the degree to which an investor can increase operating income by increasing their revenue.  Most of the aforementioned fixed costs can’t be reduced during an economic downturn, at least not by much.  But they also don’t increase much during a market upturn.  When rents increase faster than expenses, more cash flow is produced.  This translates into higher returns, hence higher operating leverage.  But it can also work in the opposite direction, magnifying losses. It is important to understand both sides of the spectrum. 

The bottom line is that leverage, properly applied, can increase returns without dramatically increasing risk. It’s important to gauge the amount of leverage used and whether it could put a property in peril during a downturn.  Look closely at the business plan and assumptions. When used appropriately, leverage can be great for your portfolio, but make sure it is used conservatively.


At Cira Capital Group, we help busy professionals passively invest in lucrative real estate assets by creating private real estate funds, pooling investors’ capital with our own, and investing with a world-class team of professionals.

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