Top real estate investors know they need to take advantage of leverage if they want to grow their portfolios of single-family rentals or multifamily properties. By using the equity in their current properties to purchase additional homes, investors can continue to grow their monthly income from rent rolls.
So it is vital for investors to know how to use leverage and, more importantly, when to use leverage. This post describes five key factors that help investors make optimal decisions about creating leverage.
Loan Terms: ARMs, Prepayment Penalties, Yield Maintenance, Seasoning Requirements
Financing for real estate investments is about much more than the listed interest rate, or even the fees on the loan. Many of the specifications found lower on the term sheet can play a huge part in your ability to create leverage. Three particular items to note are ARMs, prepayment, and seasoning.
ARMs (adjustable rate mortgages) are a standard financing tool that allow borrowers to lock in a lower interest rate for a certain amount of time (often three, five, or 10 years) before the interest rate adjusts based on current market rates. Depending on the interest rate environment, these ARMs can dictate whether it makes sense to pull equity out of a property through a refinance, or to sell a property outright, or to stay with an existing financing instrument because it has an advantageous interest rate. Knowing the timeline of your ARMs and how it compares with financing you can get at the moment will help you make wise leverage decisions.
Prepayment penalties dictate that a borrower must pay a certain amount of points if they pay off a loan with cash or, more likely, through a refinance before a certain point in time. Real estate investors will often find loans with step-down prepayment penalties that decrease over time. Again, knowing these terms and the dates associated with them will help investors time leverage decisions correctly.
Some lenders offer financing with yield maintenance requirements that function similarly to prepayment penalties. This may occur in concert with prepayment penalties, leading to a small ideal window for refinancing. Wise investors understand how yield maintenance works and account for the timing of the terms in their leverage decisions.
Seasoning requirements impact a borrower’s ability to refinance a property. Many lenders require an investor to hold a property for a certain amount of time (usually a year or two) before they are eligible for a refinancing loan. That means investors may need to execute a bridge loan that covers the seasoning period before they pull equity out of a property to create leverage. These seasoning requirements can vary from lender to lender, so investors need to do their research to find out what kind of seasoning timeline they need to plan for.
As investors consider the impact of the terms of the loan itself on leverage requirements, they should also consider the tax implications of creating leverage at any specific time. These include federal taxes but also widely variable state and local taxes, so borrowers need to fully understand these tax requirements. A good tax professional who is well versed in real estate can be worth his or her weight in gold in this area.
Property Management Ability
Growing a real estate investment portfolio may be a way to create wealth, but it is certainly a way to create work. The more doors an investor owns, the more doors he or she will have to manage. So a smart investor will make leverage decision based not just by looking at the spreadsheet but also by considering property management bandwidth. Can they manage more doors? Is it time for them to outsource property management? Do they have the right property management company in place to expand? These are important questions, because creating leverage will require more time in managing properties and tenants.
Long-Term Goals and Risk Tolerance
The first three factors help investors decide what they could do to create leverage. This key is more personal, as each investor decides what he or she should do. What is your risk tolerance level? How heavily leveraged do you want to be? Is the No. 1 thing extending leverage as much as possible to build up a portfolio? Or do you want a more secure strategy that provides steady income while minimizing risk? No one else can answer these questions for you as an investor, so it’s important for you to match your leverage strategy to your personal financial goals.
Once you have examined these first four factors, you’ll have a good idea of what kind of leverage you should create. Then it’s time to find the deal that will let you take advantage of that leverage. Some investors may choose to create leverage first and then hold onto cash until the right deal comes along; others may choose to create leverage while purchasing a new property by doing a cash-out refinance or by cross-collateralizing existing portfolio properties with a new one.
When you know what leverage you can and should create, and you find the right deal, you’re ready to use leverage to your best advantage. Finding a lender like Lima One Capital that looks for win/win financing solutions will make the leverage process easy and ultimately successful.
Dana Wasson is the Director of National Sales for Lima One Capital, the nation’s premier lender for real estate investors.