Before buying an investment property, you need financing. Using leverage is simply using other people’s money to make more money for you.
Acquiring leverage also works best when property values are on the rise. There are several ways real estate investors get funding for an investment property. Let me tell you what I did and what someone getting started might do.
What Is Leverage?
Leverage is using borrowed capital to increase potential profits. Simply put, it’s using other people’s money to make money for you.
For our second investment property, I asked my bank for financing, but it would not lend for investment properties in Florida. I wasn’t sure where to go next so I turned to the internet and found Quicken Loans. They were more than happy to give me a 30 year fixed loan at 25% down.
Getting Financing for Your Rental Property
With good credit, it’s not difficult to get financing for a rental property. But the financing company will charge a higher APR than if it was your primary residence. Generally 0.75 – 1.25% points higher. They also expect you to place a larger down payment, between 20-30% in total. Why?
Because the bank considers an investment loan to be riskier than a loan for a primary residence.
A large broker might want 30%, while a small lender will accept 20%. I used a local mortgage broker who was recommended by our real estate agent on our third rental.
While working with the local broker I told her my plan of purchasing a house every 2-3 years until I had enough cash flow to retire early. Perhaps this helped me get a better deal on a 30 year 5/1 ARM mortgage than I was getting at other companies.
In the end, I had such a great experience with the local broker that I told her that for my next house, I would be checking with her first. Now I consider her part of my real estate team. Shop around to find the best interest rates.
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How to Make an Offer
Now that you’ve found the home and you have pre-approval for a loan, you are ready to make an offer on the house. The final sales price and the mortgage terms will be the last pieces of the puzzle.
And the most important influence on your investment returns. The best way to improve your cash on cash return is to negotiate better financing.
Don’t let the excitement of this final step ruin what you have spent time working towards. Saving a couple thousand off the purchase price or getting a 0.5% lower interest rate will save you significantly more over the length of the mortgage. Don’t be intimidated by negotiations.
Work with your real estate agent to make a solid offer. You can offer lower than you might on your personal home because now you are thinking in terms of monthly cash flow and how to maximize potential returns, not just how much you love the house.
If the real estate market is slow or the house has been on the market for a long time you can really start off low and see how willing the seller is to negotiate.
Don’t forget that your real estate agent is working for you. If they understand that you will be buying more properties in the future, they will be working hard to keep your business.
Get Your Rental Property Inspected
After you reach an agreement with the seller you can have your home inspector walk through the property with you and write up their report.
Your purchase contract should have addendums for any major issues that come up during the inspection. Then you will have to discuss with the seller who will pay for repairs.
I like to ask questions when walking around with the inspector. I watch shows on HGTV to get an idea of what common issues contractors find in homes.
The more homes you look at, the easier it gets to spot things like cracks in the foundation, pipe leaks, and mold.
All of this helps you spot issues early when looking at the property. This also helps you decide if you should look for another or offer a lower purchase price.
Prepare Your Financials
Once under contract, the paperwork begins. If you have never purchased a home this can be a daunting process. Banks require credit reports, bank statements, pay stubs, tax returns, proof of down payment, proof of reserves (in case you need to pay the mortgage and can’t find a tenant), and more.
Before the closing date, they will pull your credit score again. They want to make sure you have not opened any new lines of credit that would affect your loan approval (and determine if you’re worth the risk).
Note: Several years ago, if you had a pulse you could get a mortgage with zero down. Now the banks are actually doing their job of assessing loans and managing risk. I don’t mind jumping through a few hoops if it helps to avoid the next major global market meltdown.
Leveraging Other People’s Money
Now that we are discussing mortgages, we can talk about the concept that sets real estate apart from other investments: leverage. Leverage is using other people’s money to make money for you.
In the stock market, you pay 100% of your money to control 100% of your investments. In real estate, you pay 20% of your money to control 100% of a property.
When you sell that property or generate monthly income on that property, you’re making money on the full value of the investment and multiply your returns.
How Does Leverage Work?
To understand how leverage in real estate works, let’s look at the example of three people who have $100,000 to invest in real estate.
Person A bought a $100,000 investment property outright. After taxes, insurance, and property management fees, the property generated a cash flow of $500 a month. At the end of the year, Person A will have made $6,000, a 6% return on investment.
Person B invested $20,000 into five different investment properties. After mortgage payments, taxes, insurance, and property management fees, the properties generated a cash flow of $200 a month per house. At the end of the year, Person B will have made $12,000 – a 12% return on investment.
Not only is Person B making more money, she also controls $500,000 worth of real estate, compared to only $100,000. This means more opportunities for home value appreciation and lower risk. Why?
Because Person B has superior diversification.
The more homes you own, the more diversified you become, which increases your potential returns. Owning one unoccupied rental home when superstorm Sandy floods your house means losing money.
With five rental homes and one unoccupied, the four others will provide an income buffer for you until you can get the home rented out. Also, you can diversify by picking different neighborhoods, different sized homes, and different renter types.
In real estate, you pay 20% of your money to control 100% of a property.Tweet This
Person C invested all $100,000 into the Vanguard REIT (VNQ), the stock market was flat for this example year but they still earned 3.30% in dividends. At the end of the year, Person C made $3,300, a 3.30% return on investment.
Person C had the lowest risk of all since she was diversified into hundreds of real estate holdings inside the REIT, but also had no control over what the REIT invested in, what rent to charge, and who they rented to. Person C’s advantage is liquidity.
If she needs her money out now she simply sells her shares. In a few days, the money is there. With real estate, selling an investment property is a long process. This is why I would never tie up money in real estate investments that I might need in the next several years.
Real estate makes up 30% of my net worth while the remaining 70% comes from workplace 401ks, IRAs, and savings. I treat real estate almost like having a long term bond allocation. My goal is consistent, monthly income for retirement.
How Much Leverage Is Too Much?
Leverage is an awesome tool, but it can work against you. There could be times when real estate values decrease several years in a row. You could find that you owe more than the home is worth. You will then be “underwater” on your mortgage, especially if you invested with 0% or 5% down.
If rent prices stay stable you can ride out the storm. But if the market crashes, you could find that rents go down. This will eliminate your profit margin and cause additional downward spirals of the housing market.
The solution is to find your personal balance between leverage and your tolerance for debt. Personally, I don’t think I will ever feel comfortable with more than five mortgages at one time. I don’t want the stress.
I know there are lots of investors out there who have hundreds of homes in their portfolios. They’re also highly leveraged. I balance my risk by saving up to buy the next property while at the same time adding extra payments to my highest interest mortgage until that is paid off.
My personal balance lies between having several homes paid off and several mortgaged homes. It might not be the ideal allocation of my money but it’s one that gives me solid returns (and lets me sleep at night).
Maximize Leveraged Real Estate
A real-world example of how you can maximize leverage is how we purchased our third rental home. I bought the house from an investor who was moving away from the area and didn’t want to manage his rentals from a distance.
The house was a four-bedroom home in good condition and in my favorite neighborhood. A young family was already renting. I knew this was going to be a great opportunity. No renovations, no repairs, just instant cash flow!
My issue was that I wasn’t planning on buying an investment property that year. I was saving to buy one the following year and I didn’t have the cash on hand for the down payment and closing costs.
But what I did have was two other rental properties that were paid off. I refinanced one of my properties for $40,000, used that money for the 25% down payment and closing costs on the third home, and then financed the remaining 75% to get the property.
There are not many other investments where you can do that. You can’t buy $100,000 worth of Apple stock agreeing to pay Apple a few hundred dollars a month for the next 30 years at today’s price.
Using leverage in real estate is an excellent way to use other people’s money to increase profits. Depending on your investing strategy, owning rental properties can be superior to investing in a REIT – and you don’t need 100% of your money to own it either.