Leverage: The Double-edged Sword of Real Estate Finance
Real estate investment is one of the best ways to diversify your portfolio and also a way to build your wealth. However, one main factor which tends to stop buyers from investing in real estate is the large capital required for the investment.
One of the unique benefits of investing in real estate property is the ability of the buyer to use leverage to increase your returns on your investment. Leverage is a common investment strategy that offers several benefits to the investor. However, a large majority of them are unaware of how to use leverage and this puts them in financial distress.
Thus some of the questions you should understand while using leverage as a technique for real estate investment include what leverage is in real estate and how you can use it in your real estate investment. You may also be pondering whether it works for or against you and if it is necessary while determining different methods to increase your rate of return from the investment.
This article will provide you with all the necessary facts you need to know while using leverage as a real estate investment strategy.
Leverage in real estate
Leverage in real estate means the use of borrowed capital to fund your real estate investments. By applying this technique you can multiply your buying capacity. By using leverage, you can invest in large income-generating properties and increase your return on investment. Thus, the less the amount you invest the more is the leverage and in turn the return on investment.
The main idea behind the use of leverage to finance your real estate investment is to enable you to invest using borrowed funds in properties that are otherwise over your limit. To leverage your property, you can choose to lend money from Bank, Credit union, Private money lender, Hard money lender, etc. Mortgage and loans are some of the most common ways to leverage money in real estate.
Imagine you are planning to invest in the real estate market with Rs. 30 Lakhs and there are two property options available to you. The first option is a property which is a small studio which costs around Rs. 20 Lakhs and the second option is a building which costs you around Rs.75 Lakhs. Here the first option may look perfect as it is below your budget. However, investing in the second option through leverage will be a better option while you consider the investment in the long run.
It is a known fact that land is an appreciable asset and the value of the property will rise in the future. Thus imagine that the location in which both the property option mentioned earlier is situated undergoes around the appreciation of 10%. You will earn a profit of Rs. 2 Lakh on your first property which you invested without leverage and you will earn a profit of Rs. 7.5 Lakhs on the second proportion option which you invested through leverage. By investing in rental real estate properties you can also finance your EMI through the rental income.
The lender will sanction your loan after evaluating the property and the income that could be generated from the property. He will also cross-check your credit before sanctioning the loan amount. They will also let you know as to how much they are willing to finance for you and how much you are required to make from your pocket. For example, you are purchasing a luxurious property for Rs. 1 Crore out of which the lender is ready to fund 75%, i.e. Rs. 75 Lakhs and you are required to furnish the remaining Rs. 25 Lakhs from your funds. By investing in rental real estate you can also pay off your EMIs using the rent earned on the property.
Benefits in investing through leverage
Leverage can be beneficial as well as risky. It is beneficial as long as you know how to use it. Some of the advantages of investing through leverage include:
Higher return on investment
The first and the most important benefit of investing through leverage is that it enables you to get higher returns on your investment. When you finance a rental property through an investment loan or mortgage, you are opening yourself to a stable income in the form of rent, thus increasing your return on the investment. You can also use the rent earned on the property to repay the loan EMIs and increase your equity in the property as well.
Leverage can also increase your profit when the interest paid on your loan is less than your rate of return. For example, imagine you are earning a profit of 10% and the interest on your loan is 6%. In this case, you are earning an additional 4% apart from the lender’s money.
While evaluating the investment through leverage, you must evaluate based on a cash-on-cash return basis. To calculate using this method, you will have to deduct the loan repayment amount from your earnings from investment to determine the amount you are saving.
Own properties beyond your budger
As already explained earlier, the main idea behind investing through leverage is to make you purchase a property that was otherwise beyond your limits. For example, there is a property that may cost around Rs. 1 crore situated in a prime location for which rental income is also high. You are unable to purchase the property as you are; you do not have enough money to invest in the same. In such a situation instead of giving on the investment opportunity, you can invest through leverage or borrowed funds. This in turn will also ensure you have a better cash flow and bigger tax benefits. It will offer you more appreciation benefits as well.
By investing in real estate through a loan or borrowed funds, you are also eligible for tax reductions under section 24 and Section 80 of the Indian Income Tax Act. Some of the tax reductions on homes invested through home loan include a deduction for Interest Paid on Housing Loan, deduction in respect of interest paid towards home loan during pre-construction period, deduction on principal repayment, the deduction for stamp duty and registration charges, additional deduction under section 80EE, additional deduction under section 80EEA and deduction for a joint home loan.
Risk in investing through leverage
Investing through leverage also comes with some amount of risk. One of the major concerns for the investors following leverage strategy is that irrespective of when you will receive the rental amount, the EMIs on your loans will be due. While financing through borrowed capital, the lender will enjoy a lien on the property and is often referred to as mortgage or the deed of trust. On your failure to pay your dues on the property, the lender can foreclose your property. In such a situation you may also face the risk of losing all your investments.
Sometimes the value of the property may fall when contingencies arise, in such a situation you may also stand a risk of not being able to repay the loan and end up losing your equity in the property. Thus in such situations as well you stand at a risk of investing through leverage.
Here are some tips by which you can reduce the risk of investing through leverage:
- Prefer Home loans that come at a lower interest rate and other cost associated to taking the loan
- Invest in Multiple properties
- Prefer Long term loans as the EMIs will be lower.
- Prepay whenever possible.
- Plan your finances
Owning a home of your own is a dream to most of us Indians. A real estate investment is considered to be on of the best ways to invest as well. The main issue in real estate investment is that it requires large sum as capital. Many have realized the benefit of investing in real estate property through leverage while some still stand unaware of the benefits. By financing your property through leverage, you can invest in any property of your choice and also avail tax benefits on your purchase. However, investment through leverage can be a risky business as well. By knowing how to invest and planning your finances you can overcome these risks.
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Leverage in real estate FAQ's:
You can leverage money in real estate by borrowing from Bank, Credit union, Private money lender, hard money lender, etc. Banks are the most common lender and there are several tax benefits attached to investments using bank loans.
You can avail of a home loan from your bank. The banks will conduct an evaluation process on the property and also on your credit history to determine the loan amount you are eligible for. Most of the banks do not provide you with the money to pay down-payment. You can opt for options such as a personal loan, etc. to furnish your down payments.
Leverage in real estate means the use of borrowed capital to fund your real estate investments. By applying this technique you can multiply your buying capacity.
It is recommended that you invest in real estate through leverage. By using leverage, you can invest in large income-generating properties and increase your return on investment. Thus, the less the amount you invest the more is the leverage and in turn the return on investment.