One of the best descriptions of real estate leverage can be found in a poem by Henry Wadsworth Longfellow:

There Was a Little Girl

     Who had a little Curl

Right in the middle of her forehead.

      When she was good

      She was very very good

But when she was bad

     She was horrid!

A critical and fundamental question that real estate investors must deal with in every transaction is how much leverage to apply to their purchase. Each purchase consists of two parts: debt and equity.  The greater the ratio of debt to equity in the financing mix, the greater the leverage. The greater the leverage the greater the chance for gain or for loss. The easier it is to obtain maximum leverage the greater the temptation to use it.

Properly used, debt is a powerful tool to produce maximum returns. Here is an example of how this works:  An investor finances a $1,000,000 purchase using $800,000 debt and $200,000 of investor equity.  After one year the property increases in value by 10% or $100,000. Because the investor only has $200,000 of his own money in the deal, he now has a 50% return on his investment.  Can’t get much better than this!  However, looking at the downside, if the property decreases in value by $100,000 the investor now is looking at a 50% loss of his invested capital.  Can’t get much worse than this either!  This is the point.  Leverage can be good or bad – clearly there is substantial risk in using it.

In today’s easy credit environment, it is not difficult to obtain maximum leverage.  Banks are increasing willing to lend up to 80% of purchase price (or even more).  Private capital lenders (like Montegra) are more cautious and normally will not lend over 65% of purchase price.

The savvy real estate investor recognizes that leverage can be your friend or your enemy.  Making a thorough and valid evaluation of a potential investment property is key.  What are the strengths and weaknesses of this property?  Does the investor have enough liquid cash on hand to deal with problems if the investment starts to go downhill?

Although it may seem counter-intuitive to an investor, using lower leverage may be the best decision they can make in structuring their investment at time of purchase.