Category: Lending & Financing

Using Leverage to Purchase More Investment Properties

The word “leverage” tends to evoke some pretty negative emotions in a lot of people. In the world of real estate, however, it can be a huge benefit to you as an investor. With some strategic planning and good decision-making, you can leverage the equity in your current home to purchase your first investment property.

Already have an investment property? No problem! You can use leverage to pull equity out of one of your existing properties in order to purchase more and increase your portfolio.

The big mistake that many home owners make is to pull equity out of their home to purchase cars, boats, vacations and more. All of that sounds great, but what if you used that money to purchase more properties and create passive income for you and your family? Doing so can get you on the road to financial freedom and all the boats and vacations you can handle.

How Does Leverage Work?

Let’s start with an example of what leverage is and how it works. Leverage is the concept of taking the equity in your current home and using it as cash to purchase something else that you need or want. In this scenario, we will use that cash to purchase another property that can produce income for you.
Here’s an example:

  • You currently own a property that is worth $200,000
  • You currently owe $120,000 on this home
  • The equity in your home is the difference between how much it’s worth and how much you owe. In this case, you have $80,000 in equity in this property.
  • The bank is not going to give you the full $80,000 in equity because they operate based on a ratio called LTV (loan to value) and giving you the $80,000 would max you out in terms of LTV.
  • Loan to Value refers to the ratio of the mortgage line vs the actual value of a property. In most cases, the bank will not allow you to have a mortgage that is more than 80% of the full value of the home. In our current example, this means that they will not give you the full $80,000 worth of equity because that would put your loan amount at 100% of the value of the home.

So how much will the bank allow me to take in cash for my next property purchase?

    • If the bank will only allow you to have a loan in the amount of 80% of the full value of the home, you need to calculate that amount first.

• $200,000 x .8 = $160,000

  • The bank will allow you to have a total of $160,000 in loans against your $200,000 property. However, you already have a mortgage of $120,000 on this property.
  • The difference between $160,000 and $120,000 is $40,000
  • In this example, the bank will likely allow you to take $40,000 in cash out of this property to invest in your next property.

What is a Lease Option?

When using leverage to purchase an investment property, many banks will require a certain amount of income on that property in order to give you a loan for it. In other words, they want to know that you’ll be able to charge enough money to not only cover the mortgage, but also to have a certain amount of net income on top of the mortgage each month.

Many lenders will expect you to collect 30% more than the mortgage each month in order to feel comfortable giving you the money to purchase the home. To do so, you’ll need to convince them that the property you’re interested in is worth that amount to a renter. An excellent way to do this is to setup a lease option for an interested renter.

A lease option is essentially a rent-to-own contract. More specifically, it’s a lease with an option to buy after a period of time. A contract like this will often attract a higher-quality renter who is more serious and definitely in it for the long haul.

Setting up a rent-to-own contract with a renter will allow you to charge a premium because the tenant knows that a portion of that income is going to the equity in the home which they intend to purchase in the next 3-5 years (or whatever your contract terms are). They will offer a non-refundable down payment and then pay a higher monthly rate than a typical renter, which will then satisfy the bank’s requirement of a net income of 30% over the mortgage payment.

The Importance of Cash Flow

When you purchase a buy-and-hold property, cash flow is extremely important if you want to keep leveraging properties to buy more properties. It’s not unusual for a straight rental property to produce less income than what you’ll need to convince the bank to lend you the money for it. That’s why a lease option is such an important thing to understand.

Ultimately, your portfolio will probably be filled with properties that have a variety of different rental contracts. Some will be straight rentals and some will be lease options. As tenants reach their goals and are able to purchase those properties from you, your income from those sales can be used to purchase new investments.

The ultimate goal is to keep the cash flow coming and to consistently increase it. The more you leverage properties to buy more, the higher the bank will expect your cash flow to be. Making smart investment choices and buying the right properties will play a huge role in your success at creating an ideal cash flow for your goals.

How to Choose Your Next Investment Property

In keeping with the same example, you now have $40,000 to use to purchase your next investment property. In most cases, you’ll need to put down 20% of the purchase price of the home in cash. Many lenders will not allow you to purchase an investment property with less than the 20% because their risk increases significantly.

Price

The first thing you need to think about is the price range of your property. You’re looking for something that’s priced favorably for the amount of money you have available to put down. A $200,000 home will require $40,000 down, but that doesn’t include closing costs and other fees, so you’ll need to find something at a lower price point.

Aside from the 20% down payment, you will also have to pay closing costs and other fees, which often range between 2-5% of the purchase price of the home. On a $150,000 home, this could be anywhere from $3,000-$7,500. If you find a property with a purchase price of $150,000, you’ll pay $30,000 down, plus about $7,500 in closing costs. This is a perfect scenario for your $40,000 expenditure.

Necessary Repairs

If you purchase a house that fits the price range, down payment requirements, etc., the next thing you need to consider is whether or not it needs any repairs. If so, do you have the available funds to make those repairs? How do you plan to pay for them?

Some investors use the equity from other properties (part of your $40,000) to pay for such things. However, if you opt to do that, you’ll need to choose a property that is priced even lower. Other options include available cash from your savings or checking account, credit cards or other funds that you have access to.

If you don’t have access to any funds for repairs, you should focus on finding a property in your price range that you won’t have to renovate prior to renting out.

Use of the Property

While we’re on the subject, you need to consider whether you plan to keep the property or fix and flip it. In this scenario, let’s assume you are planning to keep the property and rent it out for a monthly profit. If that’s the case, you need to look at a variety of aspects about the property that will impact the amount of rent that you can charge.

Some items to consider that will impact how much you can charge for rent include:

  • Location / neighborhood
  • Proximity to schools, shopping and restaurants
  • Quality of local schools
  • Crime rate
  • Job market
  • Comps
  • Vacancies
  • Current market trends in the area

Location / Neighborhood

The neighborhood in which you purchase a rental property will have a large impact on how much you can charge for rent. The goal is to be able to charge at least 1% of the total purchase price of the home per month. On a $150,000 home, that rate would be $1500 per month. Does the neighborhood support this amount of rent?

Proximity to Schools, Shopping & Restaurants

Many families are looking for a community that is all-inclusive. They want quick access to schools, shopping, restaurants, fitness facilities and more. Be sure to look for investment properties in areas that are well-established, or up and coming. You have to think about the location from the perspective of the potential tenant.

Quality of Local Schools

Not only is it important to be close to local schools, but it’s also important that the schools have a great reputation. Again, if you’re thinking from the perspective of the potential tenant, it’s not likely that they are interested in sending their kids to a substandard school. Do yourself a favor and find a property in a good school district so you’ll be sure to have happy tenants.

Crime Rates

This one goes along with the location or neighborhood in which the home exists. If you’re trying to rent out a single family home, it’s likely that a family is the tenant who will be interested. Families with children rarely want to live in an area with a high crime rate. Most real estate apps provide this information for you, so add this to your list of things to look for.

Job Market

If you want your tenants to pay the rent, you probably want them to have jobs. Finding an amazing house in a town or city with a terrible job market is not a great buy. Instead, look for the most robust areas of town and make sure that the job market is booming. This will help both you and your tenants to have a great experience.

Comps

Take a look at other rental properties in the same neighborhood or adjacent neighborhoods. You don’t want to price yourself out of the market. All things being equal, a smart tenant will choose the lower-priced property for obvious reasons. Be sure that your property is not the most expensive or the cheapest in the neighborhood. Aim for the middle ground.

Vacancies

If there are a lot of vacancies in the neighborhood, it could be a sign that the market is struggling in that area of town. Vacant properties will result in the supply being greater than the demand, making it a buyer’s (or renter’s) market. This will force landlords to lower their prices in order to rent out their properties.

Market Trends

On a higher level, look at the overall market trends in your city and the individual parts of time. All cities have good and bad neighborhoods and all neighborhoods have good and bad properties. If the market is volatile, do the extra leg work to make sure that whatever property you want to purchase will be profitable for you. There’s never a guarantee, but it’s best to do as much research as possible and go into it with a plan.

Conclusion

Using leverage to purchase another property is an easy way to increase your wealth over time. If you already own a home, you can leverage its equity to purchase your first investment property. Once you build equity in that property, you can use leverage to purchase another one. If you continue this process over a period of time, you’ll be well on your way to building a passive income stream and ultimately the financial freedom that you’re looking for.

Image: Pixabay

Financing Your Real Estate Purchase

When it comes to financing your real estate purchase, you have plenty of options. Many investors pay cash for their investments. This is an attractive option to sellers because the closing process is expedited and the risk of loan denial by a bank is eliminated. In return, cash buyers often receive a lower purchase price. If you don’t have a bundle of cash readily available to purchase real estate, have no fear! There are a multitude of financing options available today. We’ll cover fixed rate and adjustable rate mortgages and explain the different mortgage types, including conventional, FHA, and VA mortgages. Finally, we’ll differentiate between conforming and non-conforming loan types.

The main difference between fixed rate and adjustable rate mortgages is the interest rate. Interest is the price you pay for borrowing money, and the interest rate on your loan can significantly impact your return on investment. This should be intuitive; the more money you pay to the bank, the less money you get to keep as profit. With a fixed rate mortgage, you have the same interest rate for the entire life of the loan. This is beneficial for planning and budgeting because you can be assured that you’re “locked in” to pay the same amount of interest every month. There are no surprises with a fixed rate mortgage. Fixed rate mortgages are typically offered on a 15-year or 30-year basis.

On the flip side, interest rates change periodically with an adjustable rate mortgage, or ARM. For instance, a 5/1 ARM has a stable interest rate for the first five years, after which it adjusts every one year. This can make financial planning for the real estate investor difficult. Let’s take, for example, an investor who pays $300 in mortgage interest each month and earns a healthy $400 monthly profit on a rental property. After five years of a stable interest rate (and stable interest payment of $300 per month), the investor’s adjustable rate mortgage has an interest rate adjustment. Now the mortgage interest payment jumps up to $375 per month, and the monthly profit subsequently drops to $325 per month. It’s common for adjustable rate mortgages to have a very low introductory interest rate which can be attractive to short-term investors. Once the adjustments kick in, however, they are commonly tied to a national mortgage index. Investors may prefer to use an adjustable rate mortgage to take advantage of low interest rate periods and take a chance that they won’t experience high interest rate periods. It’s a gamble, but it depends on the investor’s individual attitude towards risk.

Once you decide between a fixed rate or adjustable rate mortgage, you’ll choose the mortgage type, including conventional, FHA, or VA. The differences between these mortgage types have to do with whether the loan is insured. Conventional mortgages are not insured or guaranteed by the government. The minimum down payment requirement for a conventional mortgage is 5% for a primary residence and 20% for an investment mortgage. VA loans are part of a program offered by the U.S. Department of Veterans Affairs to military service members and their families. One huge benefit of VA loans is that there is no minimum down payment requirement! However, real estate investors cannot use VA loans to purchase investment properties, as the program requires the borrower to use the property as a primary residence.

FHA mortgages are insured by the Federal Housing Administration. The minimum down payment requirement for an FHA loan is 3.5% which makes it an attractive alternative for many personal home buyers. FHA loans have two main disadvantages for the real estate investor to consider. The first is that FHA loans are primarily restricted to buyers who intend to occupy the property they are purchasing. The second is that FHA loans require the borrower to pay for private mortgage insurance, or PMI. The price of the PMI is determined based on the borrower’s credit score, and it adds another monthly cost for the real estate investor to account for. One workaround to the FHA loan residency requirement is for the real estate investor to live in the property for some time and rent it out later. This is ideal for people who are just getting started in real estate investment and still need a place to live for the time being. As you can tell, these are all valuable considerations for the prudent real estate investor.

Another concept related to mortgages is based on the size of the loan in question. As a real estate investor, you will often make purchases of varying size. For example, one year you may purchase a single-family home as a rental property, and the next you may purchase an apartment building with 12 units. These two investments will carry two very different price tags. Depending on the size of the mortgage loan you need, you’ll fall into either the conforming loan or the jumbo or commercial loan category. Conforming loans meet the underwriting guidelines that have been established by the government. Non-conforming loans may also be granted, but they are typically accompanied by adverse factors like prohibitively high interest rates. Jumbo loans exceed the size limits established by the government, and for this reason the lender considers the borrower to be high-risk. To compensate for the higher risk that the lender takes on, it may require higher down payments, higher credit scores, and higher interest rates.

There is no shortage of factors that will impact a real estate investor’s investment – and mortgages are just one area of contemplation. If you’re not able to purchase an investment using all cash, then a mortgage is a necessary evil. Mortgage payments are a huge factor that impacts the overall profitability of a real estate investment, so make sure you choose the mortgage type that suits your investment goals. Be sure to work with a reputable mortgage broker that can help you understand the intricacies of choosing which mortgage is right for you.

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