Real estate is a unique asset class for a variety of reasons: it is less volatile than stocks or cryptocurrency investments, it can offer long term steady growth and it’s a physical, durable entity that is by definition, scarce.
Real estate also offers leverage and can be effectively wielded to increase the value of your investment. Let’s take a look at what leverage is exactly, and how it works.
What is leverage in real estate?
Leverage is a means by which you can increase your return on investment by using borrowed capital. Essentially, you can use debt to better an investment. Leverage is used in various fields, but especially real estate, and wielded by dedicated investors and first time home buyers alike.
It may seem like a fancy term used by professional wheelers and dealers, but it’s used by average Canadians every day. When you go to the bank to apply for a mortgage to buy your forever home – that’s leverage.
How leverage works
Real estate properties can be mighty expensive. In Canada, home prices continue to skyrocket, and most people don’t have enough money on hand to buy a piece of property straight up. The same is the case for commercial real estate opportunities. addy, for example, invests in institutional grade CRE properties that may cost anywhere from a few million dollars up to $100 million.
So how does someone invest in such a highly priced but lucrative asset? Leverage.
For example, If you’re buying a home for $1 million, you don’t need $1 million in your bank account. Instead, most buyers would offer 20% of that price as a down payment and take out a loan on the remaining 80%.
That loan is often referred to as ‘other people’s money,’ and can help an investor gain value over time. For example, with that home worth $1 million, if that value increases by 10% in one year (which is somewhat conservative considering the Canadian market in recent years), then the value of the property is now $1,100,000. By paying $200,000 up front and borrowing the rest, the purchaser found a worthy investment where in one year, they gained $100,000 in value.
The loan, meanwhile, continues to be paid over time while the property gains value.
Dangers of real estate leverage
We offered an ideal example of how leverage can benefit an investor. There are, of course, some dangers. What if the property doesn’t increase in value? Now, that certainly isn’t the trend of late in the Canadian market, but it certainly is possible. That means you are losing equity over time having borrowed money on an investment that is depreciating.
Drawbacks may depend on how you are using the property too. If it is purely an investment, where you are a landlord to various tenants, then vacancies, maintenance fees and fluctuations in rent can cause you to lose money as well.
Taking out too big a loan and over-leveraging can set you up for losing money in both the short and long term.
This downside is magnified for commercial investors, who are often looking to take complete control and operation of a property without paying all the money up front. In some ways it can be seen as a gamble on themselves: if they do well managing the property with successful tenants, then money should come in. But if management and maintenance is poor, or if due diligence was lacking, then the property may lose money over time.
How to use leverage in real estate effectively
As we’ve talked about before, the best way to start investing is to plan. Set a realistic goal in mind without stretching yourself too thin. Consider the possible risks of a real estate investment – or any investment for that matter – so that you are prepared for a downturn in the market.
A proper budget with a reasonable down payment is key to success. While leverage can be a powerful tool, you don’t want to put down so little money that your loan rate negates any potential gains on your property. At the same time, you don’t necessarily want to pay everything up front since you can use other people’s money to make the investment more lucrative.
Investing with addy
Through crowdfunding, addy lowers the barriers to entry in the real estate market while spreading out the risk across multiple parties. Members can invest anywhere from $1 to $1,500 towards a property, but are not responsible for any management or maintenance. While the money is locked into the investment, addy provides a timetable for potential returns, which often includes annual distributions and sometimes even a potential sale of the property.
Fractional real estate allows addy members to potentially earn passive income without having to do all the work that comes with buying and selling a piece of property themselves. With addy, everyone can achieve the dream of property ownership.