Leverage in Real Estate: Leveraging Real Estate to Build Wealth & Generate Returns
This article is part of our guide on fannie mae and non-recourse loans in multifamily, available here.
One of the many attractive components that make cash-flowing commercial real estate investments so attractive to a real estate investor is the monthly cash flow these rental properties possess and the ability to leverage in commercial real estate to acquire assets with financing.
One of the main goals of passive investors is to locate low to moderate-risk investment opportunities that generate a solid risk-adjusted return. The higher the return on capital, the lower the amount of real estate investors’ money put into a deal. It’s easy to understand why a company borrows money from a bank to buy real estate. However, once you have this notion, you’ll see why multifamily syndication, for example, uses various kinds of debt and leverage and isn’t always financed with half equity and half senior debt or even 100 percent equity.
In this guide, we’ll talk about how acquiring cash-flowing commercial real estate investments produces higher returns over and above the cost of borrowed capital and how we leverage debt to build wealth. We’ll also cover how to not over-leverage in real estate and what the global financial crisis of 2008 taught us about leverage in the real estate market.
Leverage in real estate - (Leverage real estate definition)
Leverage in real estate investing is defined as using borrowed capital like a mortgage/debt to acquire or refinance a property because you believe that the expected profits from the real estate far exceed the interest payable on the mortgage/debt.
Building wealth through real estate investment is crucial to providing financial freedom. To real estate investors, leverage works to their advantage, especially in the long run, as the property’s value appreciates. But it can also lead to significant losses if asset values fall below the mortgage amount on the property.
Leverage in real estate example
Debt in any real estate investment can enhance the overall returns on a real estate project. In the example below, I compare and break down doing a deal with 50% Leverage Vs. 75% Leverage.
Leverage in commercial real estate
Leverage in commercial real estate on stabilized real estate assets is overall pretty conservative. Most commercial lenders that lend on stabilized assets are funding on a 1.2-1.35 debt service coverage ratio (DSCR). Typically lenders want to see a 1.25 DSCR.
This means they have loan-to-value (LTV) caps on how much they can lend. Still, the borrowers of the commercial asset are only getting loan proceeds based on a spread between the property’s net operating income (NOI) and a healthy amount of debt that the property can service based on the DSCR.
The higher the DSCR, the higher the loan proceeds you could receive as a borrower. In a high-interest rate environment, LTVs drop as your debt service payment is higher due to higher interest rates. This further insulates the lender and the borrower as they’re only being lent funds that they can comfortably afford to pay.
Acquisition Leverage for real estate investors example
In the above acquisition example, you can see that the lower leveraged rental property requires more equity or cash from real estate investors to acquire the same $10,000,000 property compared to the higher leveraged deal. That’s $5,000,000 of equity needed for the 50% leveraged deal and $2,500,0000 of equity required for the 75% leveraged deal.
Sale/Disposition Real Estate Leverage example
In the above sale/disposition example, let’s say both scenarios with different leverage have the same $16,000,000 sales price, and each project was held for only three years.
This shows that the real estate property with 50% leverage has a slightly higher net return on equity by $450,000, but on a return basis, the 75% leveraged deal produced a much higher yield. The returns were almost double, a 186% return for the 75% leveraged deal vs. a 102% return for the 50% leveraged deal.
Leverage allows you to put more cash to work
In the above example, I show how instead of placing my $5,000,000 into one deal with 50% leverage, I invest it into two separate 75% leveraged deals. This allows me to put my cash into two higher-yielding deals for a higher blended rate of return.
How much leverage real estate is recommended?
The LTV ratio is the proportion of a property’s value used to determine how much debt will be on the property/or has already been incurred compared to the property’s value.
- For example, Let’s say you have a property worth $10,000,000, and we acquire a loan of $7,500,000; this would represent an LTV ratio of 75%. LTV ratios generally range from 65%-75% LTV; in some instances, the higher end of LTVs would look like 80%-85%. Generally, investors should expect a higher rate of return for higher leveraged deals, like an 85% LTV compared to a 70% LTV, to compensate for the higher risk.
Just like most things in life, overuse of anything is not recommended, the same goes for leverage in real estate. The 2008 global financial crisis was a great example of how too much leverage can sink you.
- For Example, Let’s say you owned a house valued at $300,000 in 2007 before the housing crash and had a Loan-to-value of 85% or a $255,000 mortgage. When real estate values crashed the following year, your property was valued at $200,0000. That would mean that your property is “underwater,” meaning the mortgage is higher than the property’s value, which can also be referred to as negative equity. Lenders/banks were insolvent during this period, unlike today, and were allowing much higher leverage.
Debt vs. inflation
The time value of money is crucial because today’s dollar is worth more than tomorrow’s. This is, of course, due to many factors, but inflation’s erosion of the dollar is the main contributor. What helped accelerate that devaluation of the dollar is the unprecedented trillions of printed stimulus money that the federal reserve employed to reinvigorate economic activity since the beginning of 2020. This is excellent news for borrowers who utilize leverage to purchase real estate since they are paying back the money they borrowed from lenders, but it is now worth less than initially borrowed.
A healthy asset class, such as multifamily real estate, keeps up with inflation. This is due to the ability of landlords to raise rents naturally by 2-3% each year. It widens the gap between what investors leveraged to acquire the asset years ago as property values continue to appreciate.
If we get to a point where there is hyperinflation, leveraging real estate becomes even more important since this type of investment will serve as an effective hedge against inflation.
This is how leveraging real estate can affect the final return generated by your investment. When you purchase a property using only cash, it does not generate any additional returns since you did not use leverage to make the initial purchase. Leveraging more or less of that asset class will determine how high of a return you get from leveraging that particular property. The more you leverage a particular property, the higher your return rate will be because more money comes back into play and diminishes the overall risk associated with leverage. Also, cap rate spreads continue to widen from the 10-year treasury to support the outlook on further value appreciation.
Do most millionaires come from real estate?
There is no definitive answer to this question. However, many millionaires attribute their success to leveraging real estate. This makes sense when you consider that real estate is one of the only assets that can provide a consistent return through rental income while also offering the potential for capital appreciation.
So, is real estate the best way to build wealth? The answer is that leveraging real estate may be a good place to start if you’re looking to build wealth.
Leveraging real estate can also provide you with a lot of flexibility in how you choose to build your wealth. For example, you could leverage one property to leverage another – and another, and so on – until you’ve reached your goal or gotten close enough that leveraging additional properties makes less sense financially. This is known as leveraging up (i.e., leveraging more money for more significant returns).
Frequently Asked Questions About Leverage in Commercial Real Estate
Leverage in real estate refers to using borrowed funds to purchase an investment property. Leverage refers to the percent of the value of a real estate property that is “leveraged” through debt.
Yes, leverage is a powerful tool for wealth building. The reason leverage/debt is powerful in commercial real estate is that, unlike most investment vehicles, real estate is an asset class where debt is more easily and widely accessible. But mainly, when leverage is carved out, and at play in an investment, the less cash real estate investors have to contribute to an investment, the higher the rate of return they receive on that cash. For example, if you were to buy a property all cash for $1,000,000 and sell it next year for $1,500,000, your cash on cash return (before tax) would be 50%. Now, if you were to buy that same property but instead of using all your cash, you put down $200,000, and the bank financed the other $800,000 (80% LTV), you would have a cash-on-cash return of 350%. So as a result, you can get a higher multiple on every dollar, so instead of tying all your capital into one deal, all cash, you can buy several properties and get a higher return on your capital. That’s the power of using leverage to build wealth in real estate.
Property leverage is also referred to as the loan-to-value (LTV), and it can be calculated in a few different ways. For this example, let’s say you have a loan of $800,000, and the property is valued at $1,000,000 based on recent sales comps. To calculate the property’s leverage, you would take the debt amount of $800,000 and divide it by the property value of $1,000,000. This would give us a LTV of 80% ($800,000/$1,000,000).
The amount of real estate leverage a property should have depends on many factors. But as a rule of thumb, leverage up to 75% is well insulated. Although leverage at 80%-85% is on the higher end, this type of LTV range could still make sense if the property you acquired has a ton of value-add upside. For example, let’s say we bought a 200-unit apartment complex for $13,000,000 with an 80% LTV mortgage. Still, we made $1,500,000 in capital improvements to increase the property’s cash flow and, as a result, significantly increase the property’s value. This would be an appropriate example of where higher leverage would make sense to force the property’s value and increase investors’ returns.
Leverage in Real Estate - Conclusion
When used correctly, leverage in real estate investing can be one of the most powerful tools for wealth-building and growing your real estate portfolio. That means not using 100% of your own money but instead using borrowed capital at a cheaper rate than the yield that the real estate you purchase produces. Understanding what kind of leverage you have on the next deal you invest into as a passive investor is crucial to analyzing your risk vs. your return.
Next time you underwrite a prospective real estate investment opportunity, consider how the capital stack is structured and what kind of leverage is in place.
- Investopedia, “The Great Recession’s Impact on the Housing Market“
- Investopedia, “Does Inflation Favor Lenders or Borrowers?“
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