How to Avoid Leverage-Related Risks in Real Estate Investing

Leverage is commonly used by real estate investors to increase the power of their money. This makes perfect sense as it is better to use other people’s money rather than your own for large capital investments – such as real estate transactions.

By the way, you are relying on leverage when you get a mortgage to buy a house. This is because you are financing 80 percent of the purchase price instead of saving for years to make the same purchase in cash.

1. Assuming the Market Always Go Up

Many real estate investors get into trouble when they assume that property values will always go up. While this view is right over the long-term, real estate values are tied to the market over the last six to twelve months. As such, prices in the short-term can fluctuate wildly.

What’s the lesson here? You can’t assume that prices will always go up. Besides the example of the financial crisis, there are many cases where real estate values go down or even move sideways. These can include uncertainty in the local economy, abrupt changes in interest rates or taxes, as well as uncontrollable events such as natural disasters.

The impact of overestimating the growth in real estate prices can have catastrophic consequences for investors as they will fail to realize the returns they initially forecasted.  As such, it’s best to either use best, worst, and most likely scenarios when forecasting or go for a conservative assumption (somewhere between the worst case and the most likely case) of where the market will go. 

Doing so will ensure your financial projections can stand up regardless of what happens in the broader market and this will mean that even if things go wrong you will still be able to service the financing used to complete the transaction.

• Assuming You Can Service the Debt

Using leverage for real estate investment is a big help, but once the transaction is complete you will need to service the debt. However, many investors fail to properly run the numbers, and this can lead to issues down the road.

For example, if you are seeking to close quickly on a distressed property in New Jersey, you might consider reaching out to hard money lenders in NY because “often banks can’t make loans on distressed non habitable real estate.”

While this is a good way to acquire the property quickly, these loans are generally not the type that wants to keep on the books for the long run. As such, investors often use hard money or private loans to set up the first round of financing for a property.

However, experienced investors understand that these loans have a shelf life of usually six months to a year. If they go over this threshold, then they will be left with a loan that is very hard to service and the options are to either sell the property or refinance.

For flippers, selling the property is the option – assuming they can finish the renovation in time. For long-term investors, their choice will be refinancing. However, this assumes they can get approval for the loan.

As such, you want to make sure you understand the type of financing you are taking on before accepting the loan. This includes the payment structure, and its impact on your cash flows as well as looking at what would happen if the market softens.

Don’t just assume you can service the debt when taking on leverage, run the numbers and make sure it works.

• Assuming Funding Approval Means You Have a Good Deal

Getting financing is never easy, but you never want to conflate getting approval by having a good deal on your hands. This is another trap many investors have fallen into, largely because a lender's motivation is not to make sure the developer has a good deal or not.

Instead, lenders are trying to balance the risk and reward of a potential transaction and depending on who you are talking to for funding, they might be rooting for you to get it wrong as they could assume ownership at a fraction of the cost.

This usually happens with borderline deals that can get funding. Remember, while lenders are looking at the cash flow of the property, they are also taking into consideration your credit.

So, don’t make a mistake by assuming that just because you can get the funding you have a good deal on your hands.  Instead, run the numbers and try not to get deal fever.  This will help you to objectively review deals and make the best choices for you and your partners.