In a similar way, finance, or more specifically, leverage, is your path to growth and building real wealth.
The link between leverage and growth in real estate finance
The best way to demonstrate the importance of leverage is with a simple example. Say, thanks to a large inheritance, you have $200,000 that you’re looking to invest. You want to use that money to generate a solid income and create capital growth (growth in value) for the future that will serve as a retirement nest egg.You can use that money to buy a $200,000 house outright, that you rent out, generating a monthly rent of, say, $1,000 (just to stick with a nice round number). Then, when you retire in 20 years, you have the option of selling that property for a tidy profit. Let’s say the value of real estate in your area is doubling every 20 years, so you can sell it for $400,000. Not bad!
But what would happen if you applied the concept of leverage to that inheritance? In this case, you can buy four $200,000 properties by putting down a 25 percent down payment (that’s $50,000) on each house and taking out a 75 percent loan-to-value (LTV) mortgage on each house to cover the remaining cost.
With each property earning $1,000 a month in rental income, you’re generating significantly higher returns than you would have with just one property (granted, you have mortgage payments to cover, but you’re still making a higher profit each month). Then, when you come to sell 20 years later, after the mortgages are paid off, if each property has doubled in value, you pocket a cool $1.6 million instead of $400,000. Now that’s a nest egg.
This demonstrates how finance is key to growing your real estate portfolio and your wealth. The following figure also neatly demonstrates the link between leverage and growth.
Growth with leverage.Let’s not forget that you can also leverage existing property itself to finance future growth. In other words, you can borrow against your already owned property (through secured loans, second-charge loans, releasing equity, and so on) to release funds for further investment. This is what makes property particularly attractive as an asset class: The larger your real estate portfolio, the more options you have for using leverage to fund future growth because you’ll have more assets (properties) to secure the loans against.
The full range of international real estate finance options
Understanding the full range of finance methods and products is a huge part of investing successfully in real estate. For me, it’s right up there alongside choosing the right investment strategy — it’s that important to success.If you can get a really good handle on finance, you’ll have a serious advantage over other real estate investors. Understanding and maximizing finance can be your competitive edge.
Without money, it’s difficult to get a foot on the property ladder. So, if you don’t fully understand the financing methods and products that are out there, all you can really do is spend your own money. And from a business point of view, it’s hard to get agents, sellers, and potential business partners to take you seriously if you don’t understand what sort of financing might be available to you.But if you grasp both the concept of leverage as an investment strategy, and the different financing options available, not only do you know what’s realistic for you as an investor, but you’re also able to move much more quickly and secure appropriate finance when great opportunities arise. This ability to move fast can be a big differentiating factor in real estate success.
For example, mortgages take time to arrange and may not even be an option for the type of investment opportunity you have in mind. So, when you need to move fast or you’re looking at a not-so-standard project, a bridge loan may be a suitable short-term option.But even a simple mortgage isn’t as straightforward as it sounds. There are still lots of nuances to get your head around, such as the term (length) of the loan, fixed or variable rates, the LTV percentage (what percentage of the property’s value you can loan up to), and the value of the property.
It’s a good idea to learn about these finance products and other means of financing investments before you embark on your real estate journey. This is one area where learning on the job can cost you a lot in wasted time, wasted fees, and wasted opportunities.