How could Shakespeare be wrong? Why should anyone take out debt, or other financing, on their real estate investments?
Well, the quote from Hamlet is that of a father warning his son about the dangers of lending to friends, since hitching debt onto personal relationships can indeed cause friction.
Beyond that, though, people who counsel against investment financing often don’t have a clear understanding of the potential benefits of financial leverage.
4 reasons investors use debt to finance real estate investments
- They may simply not have enough equity capital to buy the property. Simple enough: the project is out of reach unless the investor gets some financial help.
- They have the capital, but want to borrow anyway. These investors could buy the property on their own, but choose not to because if they borrow the money they can use the extra to buy even more properties; and if the funds are spread over several properties, the overall portfolio risk is reduced.
- They want the mortgage interest deduction. Mortgage interest is tax-deductible in its entirety when used for business-purpose real estate, so other tax benefits (like the depreciation deduction) can be amplified when financial leverage is also used.
- Financial leverage can increase overall returns. This is really the key point — if an investor can borrow money for a lower interest rate than the expected rate of return on the money invested into a property, the “return on equity” is magnified.
Here’s a simple example. If you purchase, with your own cash, a $100,000 property that will give you an after-tax cash flow of $10,000, you’ll be getting a 10% return on equity. If you can buy that same property for only $20,000 down (with the remaining $80,000 financed via a mortgage loan), and the resulting interest expense (say, $4,000) reduces the property income down to $6,000, you’ve still increased your return on equity to 30%:
$6,000 ÷ $20,000 = 30%
Quite an improvement! This is where the term “financial leverage” really comes from; an investor is using financing like a lever, to “lift” (or increase) the return on his investment. At the company where I work, our entire business revolves around helping real estate investors find suitable sources of financing, with the hope that they, too, might be able to gain increased returns from the investment projects.
The risks of debt and financial leverage
Great! So should an investor simply borrow as much as possible? After all, isn’t that what those “no money down” and “other people’s money” seminars encourage people to do?
NO! There is an implicit cost associated with the use of financial leverage — the cost of higher risk.
There’s risk with all investments — and in real estate, that risk can come from economic downturns, an inability to timely sell the property, inflation, bad management, new rent control laws or an environmental accident.
- What if the property income isn’t so assured?
- What if the gross operating income of $10,000 is reduced to $3,000 because you were forced to do some repairs and couldn’t rent the property for the six months it took for the work to be completed? In that event, you’ll have negative cash flow, because the mortgage interest expense is itself $4,000 — meaning that you’d now be paying the lender $1,000 a year just to keep the property, whereas without leverage you would still be clearing $3,000 annually.
This example shows that the variance in the possible rates of return has now increased with the use of debt, or financial leverage.
While your return rates could well increase using financing, they are also now subject to greater downside risk — because “bumps in the road” become more pronounced when there are still hard-and-fast mortgage payments to deal with.
Properties involving losses instead of income are, of course, often properties that investors lose to foreclosure.
In analyzing an investment opportunity involving debt financing, you’ll need to do your “due diligence” — really, risk analysis — to see what level of financing you might be comfortable with.
Most lenders anyway won’t loan more than 80%-90% of the property’s value — they need to leave themselves a bit of a “cushion” to be comfortable with their own risk situation.
Other people’s money can help – up to a point
Financial leverage can definitely help to increase the rate of return on your money — but it is not without risk. Increasing the level of debt increases the riskiness of the investment, since it also increases the variance in possible return outcomes — and more variance means more risk.
Investors using leverage must consider whether the additional risk is commensurate with the higher expected return.
Lawrence Fassler is the corporate counsel of RealtyShares, a leading online real estate marketplace. The author does not make investment recommendations or provide investment advice, and this article should not be construed as such. He blogs regularly on real estate finance issues.