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.
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.
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
- 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.
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.
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.
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.
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.
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.
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.