Investing Strategy & Tips
Use Leverage in Real Estate Investing
By
Feb 21, 2006, 23:05

When buying income property real estate, the general rule is to use as little of your own money as possible. Although leverage can be a handicap, it can also be a powerful asset. Leverage is the use of borrowed money to magnify gains and losses. You pledge the property as security for the debt. You can borrow up to 100 percent of the cost of the property. Having realized large profits via great leverage, the real estate investor can shield most of his earnings from income taxes through allowances for depreciation and other expenses. From interest and depreciation alone, there is often a significant paper loss in excess of the positive cash flow. This can be used to shield other profits from taxes.

Leverage multiplies the economic benefits of your investment. For example, if the property appreciates at 10 percent each year, a $25,000 equity investment that buys $100,000 worth of property will enjoy a 10 percent increase on the entire $100,000. The property will increase by $10,000, a 40 percent return on the $25,000 investment. In this case, leverage has quadrupled the appreciation as a percentage of the equity investment.

Leverage also multiplies the tax benefits. Depreciating is the key to the tax shelter, and it is based on your entire investment, not just your equity. Consequently, the greater the leverage, the greater the tax benefits in relation o the size of your investment. With leverage, fewer dollars of cash are buying more property that in turn produces more tax benefits.

But leverage is a double-edged sword. Just as it multiplies your benefits when you have a good deal, it will multiply your losses when you have a bad deal. For example, if the property cited earlier declines in value by 10 percent, you would lose money at the rate of 40 percent per year. A second problem with leverage is that you must be able to carry the debt service. If you don't have enough money from the property itself to pay for interest and expenses, the property will decline. The greater the leverage, the greater the debt service. If you have to keep putting your money into the property, eventually you will sell it¡ªprobably at a loss. A property is over financed if it doesn't produce enough income to cover the payments on the PITI and still have a positive cash flow. A property may also be over financed if the total debt against the real estate exceeds the value of the real estate. If the property is over financed on either of the criteria, you have problems.

Be sure that the gross income is high enough to cover all operating expenses and to repay the debt with something left over. Since the property may generate a fluctuating gross income over the years, the debt can only be serviced if a prudent amount was borrowed when you bought the property. Thus, no-money-down deals can be as unwise as all-cash buys. A 10 to 20 percent down payment with the balance financed at a favorable interest rate is often enough to assure both positive cash and reasonably high leverage.