Using Leverage to Invest in Real Estate: Does it Impact ROI?
Unless you have accumulated a significant amount of cash that you want to invest in commercial real estate property, you’ll need to learn how to leverage debt to purchase, invest in, and grow a real estate portfolio. But what do investors mean when they say “leverage” in real estate?
Leveraging is a relatively simple idea. It’s the use of other people’s money (usually a loan from a bank) to purchase an asset. Investors use borrowed capital to fund the purchase of investment assets and grow their portfolios. These assets are strategically chosen for their cash flow, an expectation of capital appreciation over time, or both. Therefore, debt is used to amplify investor returns.
If you are looking to grow your portfolio by investing in an additional commercial real estate property, leveraging can increase your return on investment and enable you to buy assets that would otherwise be unachievable.
How Much Leverage Do You Need to Buy a Commercial Real Estate Property?
You need to use leverage to buy an investment property efficiently. Most investors who leverage a commercial property do so at the time of purchase. They allocate a percentage of the purchase price to a loan, which is then paid off from the income the property produces. Ideally, investors need to find the balance between leverage and equity to avoid over-leveraged real estate. Over-leverage real estate is a term used to describe properties with a high loan to value ratio (LTV), which is often very risky and can easily result in negative cash flow.
What is a Good Loan to Value Ratio?
A leverage ratio is calculated by dividing the loan amount by the total property value or purchase price, with some common leverage ratios including the debt-equity ratio, equity multiplier, and consumer leverage ratio. The leverage ratio is important because companies rely on a combination of equity and debt to finance their operations, so knowing the amount of debt held by a company is useful in evaluating whether it can manage and pay off its debts on time and in full.
What it comes down to is a good leverage ratio which ultimately depends on the individual investors’ financial circumstances and risk appetite. The higher your LTV, the more risk you’re willing to take in the hope of a bigger return payoff.
Why Should Investors Leverage Their Properties?
Investors don’t get into real estate just for the sake of owning assets – they want to generate profit. Leveraging allows them to maximize their returns and grow their portfolios as quickly as possible.
Investors that use leverage to purchase assets are usually banking on the property’s rental rates increasing, thus generating capital growth. Alternatively, they may have value-add ideas that will increase the property’s value and rental return. Leverage allows them to unlock nearly limitless investment potential. Many investors follow the theory that the more they leverage, the more potential they have to increase their ROI.
What is ROI?
ROI is the metric used to determine how much profit an asset makes relative to its cost. ROI in commercial real estate is the percentage of invested capital, which is recouped after deducting all the expenses such as debt servicing costs, repairs or renovations, property management, taxes, etc. It’s an excellent metric for investors to quickly tell how profitable an asset is.
Average Return on Commercial Property
Asset class type and location have a huge impact on the average return of commercial properties; however, market conditions also have a significant effect. As a rule of thumb, the more risk an investor is willing to take, the higher the ROI should be. However, according to the S&P 500, the average annualized ROI for commercial real estate is about 10%.
Of course, there are plenty of years, particularly recently, when select asset classes like multifamily and industrial properties have seen far more growth, thus improving investors’ ROI.
How To Get a Higher ROI on an Investment Property
Investors use leverage to access properties that help improve their commercial property rate of return and grow their portfolios. Let’s look at an example.
John purchases an investment property for $500,000 with a $300,000 loan, a conservative LTV of 60%. After three years and good market conditions, the property is now worth $650,000. John then chooses to leverage to buy an investment property again by using some of his equity to expand his portfolio and purchase another property for $500,000 with a $350,000 loan, being a 70% LTV. He now has two properties that provide cash flow while appreciating in value. Assuming both properties appreciate 7% each year, John will be in the position to purchase a third property using their equity in less than three years. Meanwhile, these assets generate cash flow through rental income.
This example shows how ROI can increase exponentially with the acquisition of more properties. Still, investors need to be strategic with how much they leverage, the properties they purchase, and their loan conditions. Nevertheless, it provides a basic outline of how to use leverage to invest in real estate.
How To Leverage Equity in Commercial Property
Leveraging commercial property does not have to occur at the time of purchase. There are loan options that allow property owners to leverage current equity in an asset.
Learning how to leverage equity is important for seasoned investors. The longer an asset is held, the more equity it will have either by paying down the existing loan or through appreciation. Commercial equity loans allow investors to tap into this equity with a one-time lump sum loan amount. Alternatively, they can access a commercial equity line of credit (CELOC), a revolving line of credit they can use at any time. Savvy investors use the funds from either of these loans for future investments to grow their portfolios.
For larger sums of money, it’s recommended to go through the process of a cash-out refinance with a commercial mortgage-backed security (CMBS) or debt service coverage ratio (DSCR) loan. This process increases the LTV and completely refinances the original loan using the asset’s income to justify the loan amount, meaning that the requirements placed on the individual borrower are far less.
Why You Need to Use Leverage in Real Estate to Build a Portfolio
Does leverage impact ROI? Absolutely. Leveraging assets and equity is needed to build a real estate portfolio and, of course, enable you to make more money than you otherwise could. However, it also makes it possible for property owners to build equity without putting their own cash on the line.
The amount of leverage employed depends on each individual’s risk tolerance. However, even the most conservative investors can acknowledge that leverage accelerates a portfolio’s growth. Those considering purchasing or refinancing commercial real estate assets should contact Broadmark Realty Capital. We have offices servicing the entire country and would be happy to take the time to run through your leverage options to help you optimize your investment portfolio.
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