The concept of leverage is what is known as using “other people’s money” or OPM. When investing in real estate, it makes the most sense to get a loan for a good portion of the purchase price.
To illustrate a simple example of leverage, let’s say you had $100,000 to invest. You then used that money to purchase one $100,000 condominium. (To keep the example simple, I’m using $100,000, not that there are $100,000 condos available). If the real estate market was appreciating at 5% a year and you held the property for five years, the condo would be worth $122,347 or a gain of $22,347. Now let’s say that instead, you took that same $100,000, and put $20,000 down on each of five $100,000 condominiums. You now own $500,000 worth of real estate. If it appreciates at the same 5% a year for five years, it would be worth $638,140 or a gain of $138,140 on the same $100,000 investment. As you trade up, it is important to keep your equity position at a level that allows you to survive downturns in the rental market.
Putting leverage to work for you
Most people start investing in real estate by buying their personal residence. Yet the majority of Americans will stop there in terms of building their real estate portfolio. This is because when people are motivated to buy their first investment property, they are often told they will need a 20- or 25-percent down payment. Finding it tough to save for that large of a sum, most go no further. However, if you are willing to move from house to house frequently, there is a way to build your portfolio with smaller down payments and fully apply the concept of leverage.
Move often, build a real estate portfolio
Anyone willing to move often can employ this form of investment strategy. While it might be difficult for a family with children to move often, change schools, and make new friends, among other issues, that same family might be willing to move within a neighborhood as they acquire several single-family homes. A young couple might be willing to move periodically before they have children. An empty nester couple with no kids at home may choose to build their portfolio before they retire. As in most investments, but especially in real estate, the earlier in life you get started, the better.
Keep the old house
Over my career, whenever someone contacted me to sell their old house to move up to the next one, I always suggested they keep their old house as a rental. Clients have often been confused as to why I would not want to list their old house and make a commission. My answer is that I always suggest renting out your first home because renting it is the initial step in building a real estate portfolio. If you did this four times before you retired, you could be living in your fifth personal residence with four rentals that would provide retirement income.
Buy early in life, buy often
In the above example, you might be able to acquire four properties over 30 years of working life, buying with owner-occupied financing each time. But let’s increase the goal to owning 10 single-family residences. Potentially, you could move 10 times in 10 years, buying and keeping 10 homes. I say potentially because lending rules change all the time.
The first step in starting this investment program is picking a lender to obtain a loan pre-approval. In addition to getting pre-approval, check with the lender about the current rules regarding the following:
- What is the down payment required for owner-occupied financing? Markets change, but 5% down would likely be available.
- What will the interest rate be? Will Private Mortgage Insurance (PMI) be required?
- How long would you need to live in the home before buying your next owner-occupied home?
- How is rent considered for qualifying for buying the next property and future ones?
- Is there a limit on the number of mortgages I can have?
- Where do I stand on qualifying for future purchases?
Buying 10 properties in 10 years! Is it really possible? Maybe, maybe not.
There are many factors involved:
- Current lending rules
- Is there any inventory to purchase?
- What is the price range necessary to be acceptable for owner-occupancy, yet good for being a rental after moving on to the next home?
- What is the rent? What is the loan payment?
- What are the other expenses?
After the loan payment and expenses are accounted for, is the cash flow negative or positive? If negative, it might take a while longer to allow rent to catch up to the loan payment and expenses. If there is negative cash flow, you can think of it as a deferred down payment. You just have to determine how much negative cash flow your budget can handle.
Will this investment program work?
Again, there are many factors involved.
- True appreciation of real estate over time.
- Rental increases over time.
- Taxes, maintenance, repair, and misc. expenses.
- Vacancy rates
- Principal Reduction
The success of the program is dependent on values and rents going up over time. Each month, when a loan payment is made, hopefully, supported by the rent, the loan balance goes down each month. In a perfect world for investors, values and rents keep going up and each month the property gets closer to free and clear.
FHA has been known for years for helping first-time homebuyers get started with low down payments. They also have owner-occupied programs for purchasing 2-, 3-, and 4-unit buildings. You just have to live in one of the units.
This is a great opportunity to start an investment portfolio. There are maximum loan limits, making it impracticable in some markets. In markets where the loan limits cover the values available, a four-unit can be purchased with only 3-1/2% down!
Your Realtor® and mortgage lender can work together to formulate a plan that works for you.
By Duane Duggan. Duane has been a Realtor since 1982. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, e-mail [email protected], call 303.441.5611 or visit boulderco.com.