Understanding Leverage in Property Investment

February 23rd, 2024

Leveraging simply means using borrowed money to enhance returns on investments. With property in particular, leverage works by financing a portion of the purchase price with debt. This gives you control of a more valuable asset than you could buy with all cash. As the property appreciates or generates rental income, you capture that based on the entire value while only contributing your down payment up front. This multiplication effect is the power of leverage.

However, leverage also brings risks. The more you borrow, the larger your loan payments. And if the market value declines, your equity can be swiftly erased. So utilizing excessive leverage at the wrong time can lead to foreclosure. The key is balancing upside with manageable levels of debt.

Determining If You Should Use Leverage

Before tapping into leverage strategies, review your current assets, incomes and liabilities. What can you comfortably leverage without overextending your finances? Those close to retirement may want to be conservative, while younger investors can be more aggressive. Make sure to run the numbers on projected returns versus costs at various leverage amounts. Crunch a few what-if scenarios around rising rates, vacancies etc. This will reveal how much leverage makes sense for your situation. The goal is reaching that “sweet spot” of maximizing upside potential while ensuring manageable loan payments if things don’t go as planned.

Assets That Can Be Used for Leverage

Four major pools of capital can potentially be leveraged:

  1. Home Equity – For homeowners, tapping home equity via lines of credit or cash-out refinancing unlocks one of the most affordable leverage sources.
  2. Investment Accounts – Brokerage/IRA accounts containing stocks and bonds can leverage those assets via securities-backed lending. Only a portion of the account value can be borrowed with maintenance margin requirements.
  3. Retirement Funds – Certain 401K/IRA loans or withdrawals may enable accessing retirement funds prior to age 60 by financing the withdrawals to avoid early distribution penalties.
  4. Other Assets – Cars, jewelry, art and other valuables can potentially be used as collateral for secured loans.

Tapping Home Equity to Finance Investment Properties

Two options exist for extracting equity from a home:

  1. Home Equity Line of Credit (HELOC) – This revolving line of credit offers flexible drawdown/repayment terms, usually at variable rates. HELOC rates are very competitive, but issued amounts are capped at ~80% of equity.
  2. Cash-Out Refinance – Refinancing replaces the entire mortgage with a larger fixed-rate loan pulling out equity in cash. While less flexible, it enables extracting higher percentages of equity closer to 90-95% in some cases.

Run the numbers between HELOC vs cash-out refi to see which better fits your leverage/risk preferences. Consult a tax professional on deductibility as well.

Using Securities-Backed Loans

Securities-backed lending allows borrowing against stocks/funds in brokerage accounts. The loan’s interest rates are very attractive, and you can access more leverage than traditional margin since maximum loan amounts are higher at around 50-75% of assets.

Just beware that dramatic market declines could trigger a maintenance margin call requiring depositing more assets. So don’t leverage beyond what you can cover.

Alternative Leveraging Strategies

If you’ve maxed out conventional financing options, some alternative sources to consider include:

  • Partnerships – Pooling money with other investors expands purchasing power and risk sharing. Align terms and strategy upfront.
  • Private/Hard Money Loans – Higher cost financing based on the underlying property rather than borrower credit/financials. Quick approvals but very high rates.
  • Transactional Funding – Raising capital to purchase a property secured against the asset being acquired. Usually via private lending networks, crowdfunding platforms etc.

Assessing the Right Leverage Ratio

Lenders assess four key ratios examining total debt burden vs income/assets:

  • Debt-to-Income Ratio – Monthly debt payments as a percentage of gross monthly income. Conforming is ~36%.
  • Debt-to-Equity Ratio – Total liabilities divided by shareholder equity. Lower numbers indicate less default risk.
  • Loan-to-Value Ratio – Loan amount divided by asset value. Primary mortgages usually require 80% LTV or below.

Compare your numbers to industry standards. Exceeding these benchmarks entails more financial risk and higher borrowing costs.

Risks To Consider

While judicious leverage amplifies investment returns, every upside has a downside. Risks to consider include:

Market Declines – Falling property values erode equity built up from your down payment and principal paydowns. Your equity cushion protects from foreclosure. But sufficient declines could sink overall ownership stake below lender allowed thresholds if over-leveraged.

Rising Interest Rates – Just 1-2 percent higher rates raise monthly payments adding pressure, especially on adjustable-rate and interest-only loans. Build overhead through fixed rates and refinancing flexibility.

Cash Flow Shortfalls – Recessions bringing higher vacancies plus rent/price drops can mean negative cash flow. Keep some financing in flexible HELOCs enabling pausing payments if needed to weather storms without defaulting.

Collateral Risks – Assets like cars or stocks put up as collateral could suffer losses from accidents, market corrections etc. Make sure leveraged amounts fit conservative loan-to-value ratios.

Tips for Managing Leverage Risk

Keys for effectively utilizing leverage without getting overextended include:

  1. Start Small – Test viability by initially buying cheaper investment properties 100% in cash without any financing. Then slowly layer in conservative leverage once comfortable with managing assets/cash flows.
  2. Build Payment Buffers – Underwrite for 15-20% above existing rates. Model scenarios with higher vacancies and lower rents. This confirms room for market variability.
  3. Focus on Growth Areas – Target metro regions with expanding populations, job growth, infrastructure investment etc. These resilient markets better withstand downturns.
  4. Maintain Safety Margins – Keep some portion of assets/equity unleveraged or quickly accessible. These emergency reserves enable covering shortfalls without catastrophic outcomes.

Before Making the Leap

Leverage enables multiplying returns while concentrating risk. Thoroughly investigate all alternatives and model worst-case scenarios before proceeding. Consult tax/legal specialists regarding structuring strategies and associated regulatory issues. Build conservative models, leaving room for error and avoid over-estimating projected returns. Apply the right risk management fundamentals from the start and leverage wisely.

At Empire 8 Property, our experienced team stands as trusted advisors for helping Filipino disability workers leverage assets and build wealth through property investment in Australia. As your trusted partner focused on your goals, we invite you to leverage our expertise in customized portfolios and smart financing strategies that multiply returns while managing risks. Empire 8 Property delivers client-centered guidance from assessing assets to optimal leverage ratios to risk mitigation. Contact us today to start your journey of confidently utilizing leverage to accelerate returns while avoiding pitfalls. With our proven, professional and client-focused property investment advice, we help chart your personalized path to financial freedom and prosperity in Australian property.