Leverage is the use of various financial instruments or borrowed capital to increase the potential return of an investment – and it is an extremely common term on both Wall Street and Main Street when talking about the real estate market.
See also: Investopedia's Net Worth Tracker
How Leveraging Works
Consider the common real estate purchase requirement of a 20% down payment – or $100,000 on a $500,000 asset. When a buyer puts only 20% of the money down, and borrows the rest, is essentially using a relatively small percentage of his or her own funds to make the purchase; the majority is being provided by a lender. That's why real estate investors often refer to the 80% remainder of the purchase price as "other people's money": It is, in fact, being provided by someone else.
Assuming the property appreciates at 5% per year, the borrower's net worth from this purchase would grow to $525,000 in just 12 months. Comparing this gain to the gain from a purchase made outright, without any loan, highlights that value of the leveraging strategy. For example, the same borrower could have used the $100,000 to make a paid-in-full purchase of a $100,000 property.
Assuming the same 5% rate of appreciation, the buyer's net worth from the purchase would have increased $5,000 over the course of 12 months, versus $25,000 for the more expensive property. The $20,000 difference demonstrates the potential net worth increase provided through the employment of leverage. Now, picture that 5% gain every year for 20 years. Over time, the use of leverage can have a significant, positive impact on your net worth.
Leverage: Increasing Your Real Estate Net Worth
Ways to Access Leverage
The easiest way to access leverage is to use your own money. In the case of a mortgage, a standard 20% down payment gets you 100% of the house in which you want to live. Some financing programs let you put even less money down.
If you are purchasing the property as an investment, you may be in a position where your partners furnish some (or even all) of the money. Similarly, some sellers are willing to finance some of the purchase price of the property they wish to sell. Under such an arrangement, you can purchase a property with little money down and, in some cases, no money down at all.
The Dangers of Leverage
Just as leverage can work on your behalf, it can also work against you. Revisiting our earlier example, if you use a $100,000 down payment to purchase a $500,000 home, and real estate prices in your area decline for several years in a row, the leverage works in reverse. After year one, your $500,000 property could be worth $475,000, if it depreciates by 5%. A year after that, it could be worth $451,250: a loss in equity of $48,750.
Under that same 5% price-decline scenario, if that $100,000 had been used for an all-cash purchase of a $100,000 home, the buyer would have lost just $5,000 the first year home prices fell.
In real estate markets where prices fall significantly, homeowners can end up owing more money on the house than the house is actually worth. For investors, declining prices can reduce or even eliminate profits. If rents fall too, the result can be a property that cannot be rented at a price that will cover the cost of the mortgage and other expenses. (If you are contemplating becoming a landlord, read "Tips for Prospective Landlords" and "Becoming a Landlord: More Trouble Than It's Worth?" for a look at the pros and cons.)
The problems get even bigger when multiple units are involved, as commercial real estate investors often put down as little money as possible. The goal is to leverage your money by taking control of 100% of the assets while only putting down 20% of the value. Consider the $500,000 in our previous example. only let's say it's a small apartment building. Since it was purchased with $100,000 as a down payment, if the value of the building declines by 30%, the property is worth just $350,000 – but the investor still must pay interest and principal on the full value of the $400,000 loan.
Should the amount the investor gets in rent decline too, the result could be default on the property. If the investor was using the cash flow from that property to pay the mortgage on other properties, the loss of income could produce a domino effect that can end with an entire portfolio in foreclosure over one bad loan on one property.
Leverage You Can Live With … And In!
Images of such leveraged purchases bring to mind those late-night infomercials where smooth-talking pitchmen suggest that you can earn millions of dollars buying properties "with no money down!" While it's possible, we don't recommend going this route. (Think about it: If you had a genius plan whereby people gave you millions and millions of dollars worth or real estate with no money down, why would you need to make late-night infomercials selling real estate buying lessons?)
Happily, you don't need to. Less exotic ways to use leverage – enabling you to buy real estate with, if not no money down, a relatively small amount down – do exist. In fact, although they may not think about it as leverage, most people are doing so if they take out a mortgage when they buy a home. They pay back the loan over a period of years or decades, all the while getting to enjoy the use of the property. The moral of the story is that leverage is a common tool that works well – when used prudently.
Learn more about leverage and its various uses in "Leveraged Investment Showdown." To learn about the perks of real estate investing, see our Exploring Real Estate Investment Tutorial and "Investing in Real Estate."