REAL ESTATE

The Risks Of Investing In Leveraged Real Estate

Investors have been using leverage to buy real estate for years. For most of us our home is our first leveraged investment in real estate. One of the world's largest leveraged real estate investors is Donald Trump, who parlayed his father's modest apartment holdings into one of today's most well known real estate portfolios. The World English Dictionary defines financial leverage as, "borrow money hoping to make more: to borrow money in order to buy a company, relying on it to make enough profit to cover the interest payable on the loan." Many of those touting the use of leverage to purchase real estate would change this definition like this one found in an internet advertisement, "leverage is the use of borrowed money to increase your profits in an investment." Of course there is no mention of possibility that the investment may not have enough cash flow to pay the interest on the loan or that it may not have a positive cash flow at all or it may decrease in value.

An entire new industry has been created to teach us how to use leverage to buy real estate. We have all seen the advertisements for books, courses, and seminars on how to make millions this way. Unlike the past few real estate cycles, abundant financing has made it easier to leverage these investments and the gurus of the industry are taking advantage of the opportunity to sell us these how-to products.

According to SMR Research Corporation, "In the first half of 2005, 38.1% of home buyers who used financing borrowed more than 95% of the purchase price. This was up from 34.1% in full-year 2004 and only 30.6% back in 2000." This increase in leverage has become available with greater use of creative financing vehicles, like piggyback loans. These loans combine a low interest rate 80% first mortgage (not requiring mortgage insurance) with a second mortgage or equity line. According to SMR, "In the first half of 2005, the piggyback figure rose to 48.2%." This is but one area where leverage is being used, the household residence.

Investors have found their home equity to be a source of leveraging their other real estate investments. By simply borrowing against the market value of their homes, they can provide the capital to make additional leveraged investments. Most of us have read about someone who made an investment in real estate with a small down payment and sold it quickly for a significant profit. This has become so common that millions of investors are doing the same thing today.

One internet site gives an example of purchasing a single family rental property and getting a pretax cash flow of 8.36% without leveraging. Adding appreciation, the pretax return would increase to 14.09%. The first year return increases greatly with leverage; with 50% leverage the return is 17.8% and with 90% leverage the return is 65.8%. The site points out, "What I would like you to take away from this discussion is a feeling of the huge advantages real estate investors enjoy." Of course this site leaves out the pitfalls of leveraging.

What are some of these pitfalls? Defaulting on the mortgage and losing the property is the biggest risk. Defaults may happen due to loss of household income, changing population patterns, competition, and changes in local and national economies. A foreclosure will not be just the loss of the real estate, but it will have a future impact on your getting credit, insurance, a job and other areas of your life. Losing your residence may change the children's schools; add commuting costs to get to work, and have other important impacts. The psychological impact is also there. None of us wants to have a foreclosure and be known as a deadbeat.

So how do we guard against such a loss? Use leverage wisely. Leverage increases your return in a rising market, but increases the risk of loss when things go wrong. Real estate investments do not increase in value on a steady upward path. Real estate values fluctuate in cycles and in different locations. Many markets today are experiencing decreases in values after the speculative excesses of last year. Professionals have learned to use these predictable cycles. They also have learned not to over leverage, then to lose everything when the conditions change.

Learn from the professional real estate investor and don't get caught up in the "get rich quick" hype of highly leveraged real estate.

Mr. Cuthill's practice is limited to court-appointed positions in large fraud cases. His work has produced the return of millions of dollars of investors' funds. For more information about him go to http://trusteeandexaminerCuthill.com/