Leveraging is a technical term meaning borrowing to invest. More specifically, financial leverage takes the form of a loan reinvested with the hope to earn a greater rate of return than the cost of interest. For years leveraging was mainly used in the Stock Market for brokerage margin accounts, that is arrangements in which investors bought stocks ‘on margin’, putting up only a percentage of the total cost. The brokerage firm effectively provided a loan for the balance. With the appearance on the financial scene of home equity lines of credit in the 1990’s, leveraging was adopted by investors and speculators in Real Estate as well.
Home equity lines of credit meant that ordinary people who had benefited from the big run-up in housing values during the 1970’s and 1980’s suddenly had access to large amounts of cash. In most cases, these were not sophisticated investors – in fact many of them knew very little of real estate investing. But they had home equity and could suddenly tap into it. The same phenomenon has happened in the early years of the millennium with a new generation of real estate investors, who have used their equities to purchase and add up inventory, thus contributing to the price increases of these past few years.
The math of leveraging has always been very seductive, both as it applies to the Stock Market and in Real Estate. All the more so at the time when markets were soaring. With leveraging, one uses other people’s money to enhance his own profits by acquiring additional interests in land. This enhancement process takes the form either of added equity, which is realized at the time the real estate asset is sold, or as additional cash-flow, as in the case of rental properties. Either way, it was easy to make a compelling case for borrowing against home equity to invest.
There are, however, pitfalls in leveraging that must be brought forth to the uninitiated investor. For one thing, while leverage allows greater potential return to the investor than otherwise would have been available, the potential for loss is greater because if the investment loses value not only is a portion of that money lost, but the loan still needs to be repaid in its entirety.
Secondly, the problem with leveraging in Real Estate does not relate to its potential value as an investment tool but, rather, to the emotion that invariably is involved in any real estate transaction. People tend to be persuaded to borrow against the value of their homes without truly understanding the risks involved and the potential distress that losses may cause, especially when the market is in retreat and prices are dropping. This is the reason why a small but increasing number of investors find themselves into the predicament wherein they have saved and scrimped all those years to pay off their mortgages and are now right back where they started.
Leveraging is a suitable strategy only for investors who are experienced and knowledgeable. Unless one is prepared both financially and psychologically to deal with what could be severe short-term losses and stick with the investment for the medium to long term, one is not a good candidate for leveraging. And even then, when the investor has the know-how and the stomach for leveraging, certain rules of thumb are always helpful:
[ ] Invest when prices are low, not high.
This sounds obvious, but unfortunately there is a natural tendency to shy away from real estate when markets have peaked and prices are falling. Conversely, when property values go through the roof everyone wants a slice of the pie. This is specifically the reason why it is so easy to convince people to use leveraging when everything is on the rise, and almost impossible to get anyone to listen when markets are in deflation.
But it is exactly during falling markets that leveraging offers the best capital returns in the medium to long haul. Interest rates are low, so the cost of borrowing is minimized. Financial institutions are looking for customers and it is easier to cut a better deal or get incentives from them than would be the case otherwise. Sellers too are more motivated and more flexible on prices and terms of contract.
[ ] Be selective in what you buy.
Go for the quality of the real capital asset. A house, or multi-family dwelling that is well maintained and well kept will hold up value better in the long run, and will save the investor money in upkeeping as well. In the case of rental properties, it will be easier to find tenants willing to pay more to relocate into a nice-looking property.
[ ] Take the profits and pay down the debt.
Greed is always dangerous in any market, and this is where most people fall. Do not keep reinvesting the profits. That is like betting all winnings on every new roll of the roulette wheel. By doing so, investors expose themselves to new risks every time they use leveraging to reinvest, and sooner or later they will lose because they do not stand on solid financial foundations. The best and safest strategy is to use cash-flow to pay down the loan, or to wait for prices to increase and then sell for a profit.
[ ] Pay the lowest possible interest.
Even though the interest is tax deductible, investors have still to pay some of it out of their own pockets. If the loan is substantial, that could amount to several thousand dollars every year. So therefore it is always advisable to shop for the best deal available, using the services of a good mortgage broker.