Anyone who’s thinking of becoming an investor in NYC real estate will no doubt come across the terms leverage and liquidity. For beginner investors, these terms can cause some confusion. And even if you are familiar with them from previous experience trading on the stock market, you must understand how they apply to real estate investing. Before you start risking your hard-earned cash in real estate speculation, make sure you know these terms and what they can mean for your investments.
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What is the leverage?
It’s hard to imagine that debt can be a good thing in real estate investing, but under the right circumstances, it can be.
At its purest, leverage is the use of borrowed capital to purchase and increase the value of an investment. The most straightforward example is when you take out a mortgage, make a 20% down payment, and secure 100% of the property.
An example of leverage
Let’s imagine you’re looking for a great investment property. Your search turns up two properties; one for $500,000 that you’ll need a mortgage to purchase and one for $100,000 that you can buy outright.
You go for the $500,000 property for which you put 20% ($100,000) down and secure the remaining 80% ($400,000) through a mortgage. Assuming that the property appreciates at 5% per year, your net worth from the purchase will increase to $525,000 after just one year.
You make an all-cash purchase on the $100,000 property. Assuming the appreciation rate is still 5%, your net worth from the investment will only be $105,000.
In the first scenario, the use of leverage netted you an extra $20,000. Now try to imagine that 5% gain every year for 20 years. In this example, leverage worked in your favor. However, it can also work against you. If instead real estate prices had fallen by 5%, you would have lost $20,000 rather than $5,000.
Pitfalls to avoid when using
Leverage can be a very effective way of increasing your return on investment (ROI), but you must understand the risks involved and avoid these pitfalls:
Counting on high levels of appreciation
NYC is regarded as a haven because of its high property value appreciation. Even if there’s an economic downturn in the rest of the country, you can expect property values and demand to remain stable. Still, this should be a concern. When considering leverage, you have to keep in mind three scenarios, best case, worst case, and most likely. Rely too much on appreciation, and your investment can become a loss or worse.
Having too high a payment
The more significant the amount you borrow, the higher your monthly payments will be. If the market softens or properties experience higher than expected vacancy rates or credit losses, you could find yourself unable to make those payments. If you can’t keep up with those payments, your property could face foreclosure.
Letting good financing cloud your judgment
Just because you can secure a mortgage with little cash overlay doesn’t automatically make it a good investment. You still need to consider the value of the property, look at the competition, and where the local market is. If your property is overpriced, appreciation will be little or non-existent.
What is liquidity?
Liquidity is the degree to which an asset can be; sold quickly or slowly and whether the price will be above or below market value. It’s also the ability to buy or sell without affecting the asset’s price. Money is the most liquid asset as it can be quickly traded for anything while real estate, fine art, and collectibles are considered the least liquid.
Having an illiquid asset, such as real estate, isn’t necessarily a bad thing as it has the potential for long-term gains. Property in Manhattan can be very illiquid because there’s always high demand and, at present, a low inventory. But if you need cash fast, the length of a sales transaction can tie up your asset until the sale is finalized, and you’ll probably have to reduce your asking price if you need it done quickly.
When considering real estate liquidity, here are the questions you need to answer when evaluating a purchase:
- How fast can a deal be made, and how long will it take to finalize the paperwork?
- How much will it cost to close the deal (closing costs, taxes, broker fees, etc.)?
- Is the property in demand, and what is the real estate market like?
You’ll also want to consider the type of property. In general, large and expensive properties are the most illiquid as fewer buyers are looking to pay large amounts, and there is more due diligence involved. As an investor, you need to plan for worst-case scenarios. You can do this by having a diverse portfolio that includes highly liquid assets such as stocks, which can be quickly converted to cash in an emergency.