Leverage is a powerful tool for real estate investors. By using leverage, investors can increase their returns on cash invested by borrowing money to purchase more properties or to make improvements to existing properties. This can have a significant impact on cash on cash returns, which is a measure of the annual cash flow of a property divided by the cash invested. In this blog post, we’ll explore how using leverage can change your cash on cash returns in real estate investing.
When you purchase a property with cash, your cash on cash return is simply the annual cash flow of the property divided by the cash invested. For example, if you purchase a property for $100,000 with cash and the property generates $10,000 in annual cash flow, your cash on cash return is 10%.
However, when you purchase a property using leverage, the equation changes. For example, if you purchase the same $100,000 property with a 50% down payment of $50,000 and a $50,000 mortgage, your cash on cash return is no longer 10%. Instead, it’s calculated by dividing the annual cash flow by the total cash invested, including the mortgage payment.
In this scenario, if the annual cash flow remains $10,000, the cash on cash return increases to 20%. This is because you’re earning $10,000 on an investment of $50,000, as opposed to earning $10,000 on an investment of $100,000. Leverage has effectively doubled your cash on cash return.
It’s important to note that while leverage can increase your cash on cash returns, it also increases your risk. A property that generates a positive cash flow when purchased with cash may not generate a positive cash flow when purchased with leverage. If the property’s income doesn’t cover the mortgage payments, you’ll end up losing money. Additionally, if property values decline, you could end up owing more than the property is worth.
To mitigate the risks associated with leverage, it’s important to understand the mechanics of real estate finance, including interest rates, amortization, and cash flow. It’s also important to be very selective in the properties you purchase, focusing on properties that generate a positive cash flow and have a strong chance of appreciation.
Additionally, using different types of financing options can help, such as using adjustable rate mortgages (ARMs) or interest only loans that have lower payments in the beginning. also, One of the best ways to minimize the risks of leverage is to spread your investments across multiple properties, which will diversify your portfolio and reduce the impact of any one property’s performance.
In conclusion, leverage can have a significant impact on cash on cash returns in real estate investing. By borrowing money to purchase or improve properties, investors can increase their returns on cash invested. However, leverage also increases risk, and it’s important to be selective and use other strategies like diversification to minimize risk. Understanding the mechanics of real estate finance and selecting properties that generate positive cash flow and have strong potential for appreciation is essential for successfully using leverage in real estate investing.