Leverage: The High-Wire Act of Real Estate Investing

Balancing Risk and Reward

Leverage is a fundamental tool in real estate investing, allowing investors to acquire properties while using their own cash for just a fraction of the total cost. Borrowing money to invest in income-producing properties can amplify your returns, allowing you to scale faster than relying solely on your own capital. However, excessive leverage can prove to be a double-edged sword—when the market is in your favor, it opens the door to greater opportunity. But if the market turns against you, it can lift the lid on Pandora’s box.

In this article, I’ll explore the benefits and some of the hidden dangers of high leverage, how it can impact long-term investment success, and ways to strike the right balance.

The Appeal of High Leverage

There are two key benefits that make leverage appealing:

            Control More Properties with Less Capital

Leverage lets investors control large properties while putting up just a fraction of the purchase price. Instead of needing $1 million in cash to buy a million-dollar building, you might only need $250,000, financing the rest.

So if you really did have a cool million hiding under the sofa cushions, you might be able to scale your portfolio quickly, in this case spreading you cash across four million-dollar properties instead of just one.

            Amplify Your Returns

I mentioned amplifying returns, and that’s the second appeal. If general economic factors or your value-add efforts succeed in raising the value of this property by 10%— a $100k increase—your equity jumps from $250k to $350k. That’s a 40% increase, a very significant return compared to what you would have had with an all-cash purchase.

The Hidden Costs of High Leverage

Leverage can be a great friend—until it isn’t. It comes with some financial risks that can erode profits if not properly accounted for. Here are some key risks:

Higher Debt Service Costs

Bigger loans mean bigger monthly mortgage payments. What may have looked like a cash cow in your DIY spreadsheet can quickly become a cash drain if mortgage payments eat up most of your rental income. Do the math before you do the deal. Is the property’s rental income sufficient to cover these loan payments, as well as property taxes, insurance, maintenance costs, vacancies, and other expenses?

Increased Interest Cost

The more you borrow, the more interest you pay over time. Even a slight increase in interest rate can significantly impact long-term costs, particularly with adjustable-rate loans. Your lender may be thrilled—you, not so much.

And keep in mind that the more you borrow in relation to the value of the property – the so-called “loan-to-value ratio” – the higher the interest rate on the loan is likely to be. Why? Because if you have little or no skin in the game (i.e., little or none of your own cash in the deal), then any lender will look at you as being a high-risk borrower and will want to be compensated for that risk by charging you a higher rate. And that higher rate means even higher debt service.

For example, consider a situation where the standard underwriting policy with your lender is a maximum loan-to-value of 80%. You apply for a mortgage with them, but half of your 20% down payment is actually coming from a secondary loan. Your first lender will consider themselves at an elevated risk and will want to cover that risk with a higher rate and possibly even a shorter loan term—all of which equals more debt service, and less cash flow. This is starting to look dicey.

Negative Cash Flow Risk

I mentioned earlier, “Do the math before you do the deal.” If the property’s rental revenue isn’t sufficient to cover debt payments and operating expenses, you’ll probably need to contribute personal funds to sustain the property. Feeding a hungry investment monster is not what you had in mind when you embarked on this journey. An unexpected vacancy or major repair can happen – they’re not uncommon – but we call our prep work “cash flow planning” for a reason. You need to leave some wiggle room to ride out surprises like that. If you burden yourself with a super-sized mortgage and its accompanying elevated debt service, you may not have that room.

Balloon Payment and Refinance Risks

While leverage can accelerate portfolio growth in a strong market, it can become a liability during downturns. You find that you have a struggle on your hands if property values decline, rents stagnate, or economic conditions go sideways.

A case in point is the balloon mortgage. Many, probably most, commercial loans come with balloon payments. A balloon is a large lump sum payoff that comes due at the end of a specified term.

The way these loans work is like this: The loan’s monthly payment, i.e., its debt service, is based on a longer term—say 15 or 20, even 25 years. That makes the monthly payment generally manageable relative to the property’s revenue. But the lender doesn’t want its capital tied up in long-term loans. So the full outstanding balance of the loan comes due at the end of something like 5 or 7 years. That’s the balloon payment. The loan has been only partially amortized, so the balloon amount could be big.

Consider the recent state of the commercial mortgage market. Lots of investors grabbed commercial financing a few years back when loan terms were attractive and highly leveraged deals seemed reasonable. Now the financing markets are in a different place and the balloon payments on those loans are coming due. Investors who took those loans are finding their properties aren’t worth as much as when they bought them, especially in the post-pandemic office sector, so they’re difficult to sell. Or owners can’t refinance the loans because the property’s cash flows are down (maybe even negative) and interest rates are up.

An example:

An investor buys a $2 million building with 90% financing and a 5-year balloon, assuming rents will keep rising forever (because that always happens, right?). Five years later, rents have softened, vacancies have risen, and interest rates have spiked. The value of the property has dropped to $1.5 million, and the lender is no longer excited about refinancing that $1.8 million balloon balance. Long story short? Our investor is now looking for a buyer—or a bankruptcy attorney.

Sidebar suggestion: Perhaps another investor’s balloon-payment dilemma becomes your opportunity to buy that property and turn it around.

Striking the Right Balance Between Leverage and Risk Management

Instead of maxing out your borrowing power, smart investors use leverage strategically. Here are some possibilities:

Conservative Loan-to-Value Ratio

A conservative LTV ratio, typically between 60-75%, can help balance growth with financial stability. Lower leverage reduces debt obligations and increases long-term flexibility.

Debt Service Coverage Ratio (DSCR)

DSCR (aka DCR) is the ratio between your property’s Net Operating Income and its annual debt service. A DSCR of 1.00 means you don’t expect to a have a dollar left over after you pay the mortgage—if everything goes according to plan. You can bet your lender isn’t giving you a loan if that’s what you’re projecting. Be sure you realistically expect a DSCR at least 1.25 before you move ahead. That suggests your property will generate enough income to cover debt payments with room to breathe.

Stress Testing Potential Investments

Did I mention doing the math before you do the deal?

You really do need to run the numbers on a potential property investment and look at them with a clear eye.

Make detailed cash flow projections based on as much real data (pun intended) as you can get. Don’t fall into overly optimistic assumptions about rent growth or other market dynamics. That’s how investors can end up getting overleveraged.

Shameless self-promotion: If you want to do the best possible (and easiest) job of running those numbers, don’t forget that RealData has three levels of Real Estate Investment Analysis software to help you do that, as well as video courses to teach you all about the methods and metrics of investing and development.

Conclusion

Leverage is a valuable tool in real estate investing, but the key is balance. By keeping your LTV ratio reasonable, maintaining adequate debt coverage and strong cash flow, and planning for worst-case scenarios, you can enjoy the benefits of leverage. It can help you scale and build wealth without the risk of falling off that tightrope.