Here’s one of property investing’s biggest secret: one of the most powerful advantages is financial leverage. But, how does it work? Leverage is generated by using borrowed capital as your funding source when investing.
Quite simply, it allows you to buy a much larger asset and increase your investments potential return, without having to pay 100% of the purchase price upfront. “Leverage enables you to make money on other people’s money,” says forbes.com.
If you are new to property investing this strategy will surprise you. Because the less cash you invest, the higher your return. Sound too good to be true? Here’s how you can make it work for you.
How Leverage Really Works
You’ve heard about all the benefits, but how exactly does it work in practice? Here is an example to show you how leverage can work for you.
EXAMPLE: The investor (you) have $60,000 to put toward a residential property investment. You can then use the capital from this investment in a number of ways:
- SCENARIO 1: Buy a $60,000 property for cash, producing no leverage.
- SCENARIO 2: Put the $60,000 toward the purchase of a $120,000 property using financing (such as a bank mortgage loan) to cover the other $60,000. This produces 50% leverage.
- SCENARIO 3: Put the $60,000 toward the purchase of two $120,000 properties using financing to cover the remainder of the purchase price. This produces 75% leverage while spreading your potential gains and risks over two properties.
Property values increase by 5% (based solely on appreciation):
- SCENARIO 1: $63,000 property value for a $3,000 gain on the cash invested.
- SCENARIO 2: $126,000 property value for a $6,000 gain on the cash invested.
- SCENARIO 3: $252,000 property value for a $12,000 gain on the cash invested.
As you can see, thanks to the use of leverage, each of these returns can be realised using the same $60,000. When put into use, it means that the more leverage an investor uses, the higher their potential gain from asset appreciation.
Experienced investors understand that not every property makes money, which is especially true when thinking short-term. Leverage is a great strategy to help you diversify your portfolio by purchasing more properties. It also creates a reduced risk property portfolio.
When Should Leverage Be Used
Optimally, leverage is most effective when the property values and rents are rising. Fortunately for Australian real estate investors, these conditions are abundant around the country today. Though you must be aware that should values and/or rents stagnate or decline, the advantages of leverage will quickly disappear.
What this means is that there are two very key aspects to leverage that you must put into practice before investing. The first is making sure that you have done your due diligence and understand comprehensively the current investing environment. The second, developing a thorough investment strategy.
Leverage is a well-proven method of increasing your real estate net worth. If done correctly, you can take advantage of this powerful advantage and expand both your property portfolio and your future gains.