Investing in real estate is not like investing in the stock market. When purchasing stock, investors can control the spread of disposable cash over multiple investments. When purchasing real estate, investors need capital and an understanding of using equity and leverage to their advantage.
As an seasoned hard-money lender in Los Angeles, I have seen unnecessary results when investors do not understand this balance.
What is Leverage?
The definition of leverage is two-fold. It uses borrowed funds to increase returns and a technique that will increase risk and the power of equity. The strategy of using leverage is a balancing act.
The Access to Leverage
The way to access leverage is through equity, or cash. The terms of access are through the lender and how it measures its risk when considering the property, the deal’s feasibility, and the investor’s qualifications to achieve the projected returns.
The confidence of the lender will be evident in the offered terms. The more confident the lender, the higher up the stack the lender will invest.
The gap is the equity, or the cash provided by the investor.
The Dangers of Leverage
This is where the balance applies. Leverage can work to the benefit of investors as equally as it can work against them. Understanding the market through a conservative eye will mitigate the exposure to risk.
In real estate, the potential for a loss in value is always present. The market supports value as the price and the rent rates.
Should rent rates fall, the property may not generate ample income to support operations or service the debt. Any projected profit will not be realized if the cap rate rises.
Leveraging Too Many Properties
The balance of cash and leverage becomes deeper and riskier as a portfolio grows. Again, a conservative approach is needed.
Many investors aim to own and control as many properties with as little money down as possible. This position will work if the investor has the liquidity to cover rent reductions and the loss in value. The exposure to risk increases the more an investor looks to operations to cover a loss.
I have seen too many situations where a loss of income in one property negatively affects an entire portfolio.
There is no opportunity to refinance when there is insufficient net operating income to service a loan.
Reducing Leverage Risk
There are ways for investors to hedge risk and use leverage to their advantage. Real estate is risk and common sense.
Investors should not become too reliant on past performance to indicate what will happen. If property values have continued to rise, then it cannot be assumed this will continue into the future.
Budgets and proformas must be created conservatively with an air of caution. A loss in rent income cannot be attributable solely to market conditions. Tenants must be thoroughly vetted to preserve income, and the systems for management and screening will increase operating costs. A 15%-20% vacancy loss should always be built into a budget.
This conservative eye cannot be projected onto the expenses. The expense budget must be liberal and include a line item for a reserve account funded through operations.
If a profit is realized with a cautious approach on the income side and a generous approach on the expense side, then the investment should withstand any market trend over time.
If leverage is high, then the payments will be high. Mortgage terms that are less competitive due to the low equity position translate to reduced cash flow and accumulated equity.
The increase in purchasing power is a balancing act between equity and leverage. If an investor can purchase a property with less money down–fine. But know there must be liquidity to handle the risk of loss.
Investors need liquidity to maintain competitive mortgage terms, cover any losses in operations, and expand their portfolio on a scale to meld with liquid assets.
If you are interested in purchasing real estate or need funding for your next project, contact the highly reputable and respected hard money lender in Los Angeles, PB Financial Group. PB Financial is a premier, direct hard money and bridge lender who has been providing quick funding since 2006 and has funded over 2,700 hard money/private money loans. Our objective is to satisfy your financing needs on important real estate projects throughout California in an efficient manner.
To learn more about how to successfully finance your next real estate venture, please contact PB Financial Group at 877.700.3707 to schedule a consultation or visit www.CalHardMoney.com to learn more.