Should you use leverage in real estate, or is buying a rental property with cash the better move? In this article, we’ll weigh the pros and cons of each strategy, show you how to use leverage wisely, and run the numbers so you can see which option helps you build more wealth over time!
Summary:
Leverage is another term for debt, but it comes in many forms. The mortgage on your home is leverage, a home equity line of credit (HELOC) is leverage, and a private loan from a friend or family member is leverage. Leverage is regularly used in real estate investing, as buying a house in cash is often out of reach for investors, especially beginners.
When people say “LTV,” they’re referring to loan-to-value, the percentage of debt on the property. For example, if you put $80,000 down on a $400,000 property, your LTV would be 80%, as you have a $320,000 loan. To calculate LTV, divide your loan amount by the value of the property.
Buy your first new-build turnkey rental for just 5% down with Rent to Retirement!
Rental properties are one of the only investments that you can easily use leverage to buy.
For example, suppose you’re looking to purchase a rental property that costs $400,000. Instead of paying $400,000 out of pocket, you could get a 20%-down loan and only put $80,000 down, or you could put even less down with Rent to Retirement’s 5%-down select new build financing. This allows you to get into the property for just $20,000 down.
With stocks, cryptocurrency, precious metals, and other investments, you often have to buy in full. But with 20%-down real estate, you can buy 5x the asset!
An investor uses 20%-down loans to buy one rental property per year. Each home grows at 3% appreciation (annually) and makes $200 in monthly cash flow, which also increases 3% annually. Here’s how this would play out over the next five years:
Year 1: $0 in Appreciation (down payment) + $2,400/Year Cash Flow - 3% Total Return
Year 2: $12,000 in Appreciation + $4,872/Year Cash Flow - 10.55% Total Return
Year 3: $36,360 in Appreciation + $7,418.16/Year Cash Flow - 18.24% in Total Return
Year 4: $73,450.80 in Appreciation + $10,040.70/Year Cash Flow - 26.09% Total Return
Year 5: $123,654.32 in Appreciation + $12,741.93/Year Cash Flow - 34.10% Total Return
At the end of five years, you’d have $2,123,654.32 in real estate from putting JUST $400,000 down (five $80,000 investment property down payments).
As you can see, putting just 20% generates much higher returns on your initial investment than even the stock market’s average 10% return, thanks to the power of appreciation on an asset you wholly own (but only needed 20% down to buy)!
Browse cash-flowing turnkey rental properties for sale in top U.S. markets!
So, why do so many real estate investors use leverage in real estate? Debt offers several benefits:
Rather than saving up 100% cash to buy a rental property, you can put 20% down and leverage the rest. This allows you to buy properties much faster, and it’s how regular people build entire real estate portfolios in a matter of years, rather than decades.
Buying a house with leverage gives you a higher cash-on-cash return, a metric that measures your cash flow relative to the cash invested. For example, if you buy a $250,000 house in cash, and it produces $5,000 in annual pre-tax cash flow, your cash-on-cash return is just 2%. But if you use leverage, putting only $50,000 down, your cash-on-cash return is 10%!
When inflation is high, it’s the debt holders who win. As the prices of goods rise around you, your principal and interest payment stays the same (assuming you have fixed-rate debt).
Even if you manage to save $100,000 in cash, it’s difficult to find $100,000 houses that don’t need significant repairs or maintenance in many markets. Use your $100,000 to buy a $500,000 house instead, and suddenly you have more options. Or, buy two $250,000 turnkey rentals that are newly-built or renovated, with less maintenance to worry about!
Whether you’re buying a primary residence or an investment property, you can often write off the mortgage interest on your taxes. If you’re buying in cash, you obviously don’t have a mortgage and can’t get this tax benefit.
Want to invest with just 5% down? Rent to Retirement offers low-money-down financing on select new-build rental properties!
If buying a property in cash is going to leave you with little to no reserves, it may not be worth it. Put less money down, use leverage, and have more cash on hand for vacancies, emergencies, and/or future investments!
Leverage can be a powerful tool, but it’s not the best choice for everyone. Here are a few drawbacks of using debt to buy investment properties:
When you have a mortgage, a large amount of your rental income is going toward paying down that loan balance, which reduces your net cash flow. Thankfully, tenants are effectively doing this for you!
When you introduce financing into the picture, you’re paying interest to the lender each month. Interest usually makes up most of your mortgage payment early on, and it dwindles as you pay down the loan.
It costs money to use leverage in real estate. When you get a mortgage, you’ll likely pay lender fees, origination fees, and other loan-related closing costs, which often amount to several thousand dollars.
A mortgage is a secured debt, and the property itself is the collateral. This means that if you stop making payments, the lender could foreclose on you and take back the property.
There are right and wrong ways to use leverage in real estate. The following can help limit your real estate investing risk:
You should never buy a rental property if it only pencils in a best-case scenario. Analyze every property for best-case, average-case, and worst-case scenarios to ensure you can survive the normal ebbs and flows of real estate investing. Use our rental property calculator to (conservatively) estimate returns before you buy!
If you can walk into equity when you buy, it not only raises your net worth but also gives you a buffer if home prices fall. Rent to Retirement’s new build turnkey rentals come with incentives like cash back at closing or price reductions, allowing you to potentially walk into equity upon closing while putting just 5% down.
A 30-year, fixed-rate mortgage is largely considered the best and “safest” way to use leverage in real estate. This keeps your investment property mortgage rate locked in (and you can still refinance if rates drop) and gives you a predictable monthly payment. On the other hand, floating debt and bridge loans can put you in a precarious position when that debt matures. Your interest rate could spike, or you could be on the hook for a large lump sum!
You don’t have to make the lowest down payment possible to use leverage effectively. If putting 30%, 40%, or 50% down gives you more cash flow, lowers your risk, and helps you sleep at night, it could be the right move for you.
Whether you’re using leverage or paying cash, using all of your funds on the purchase is extremely risky. You should have ample cash reserves available to cover things like emergency repairs, capital expenditures, and vacancies. A common rule of thumb is to keep enough cash to cover three to six months of expenses.
No investor should go out and overleverage themself or take on a mortgage they can’t reasonably cover. But by using leverage the right way—buying cash-flowing properties with fixed-rate debt and cash reserves in place—you could scale your real estate portfolio faster and give your investments more time to compound.
And with Rent to Retirement, you may not even need to bring 20% to the table. You could buy multiple rental properties with just 5% down and take advantage of huge incentives like price reductions or cash back at closing!
Leverage is a tool many (or most) real estate investors use to buy rental properties and scale their portfolios faster. Rather than saving up the cash to buy a property outright, you put a certain amount down (usually around 20% for an investment property) and get a mortgage for the balance. This gives you all the benefits of direct ownership without paying 100% cash upfront.
A “good” leverage ratio depends on several factors, such as the property itself, your risk tolerance, and your long-term goals. It also depends on which leverage ratio you’re using. For loan-to-value (LTV), some stick with 80% as a baseline, as going higher may result in greater borrowing costs.
Let’s say you have around $100,000 saved (plus money for reserves). You could find a $100,000 house and pay for it in cash, but you’d be limited to markets that have properties at that price point. There are better ways to invest $100,000. By taking that $100,000 and using leverage, you could put 20% down ($100,000) on a $500,000 home, or you could buy five $100,000 properties with 20% ($20,000) down on each!