Leverage occurs when a buyer acquires an asset by using their own resources for a down payment or portion of the purchase price and the balance is contributed in the form of borrowed capital. Leverage is a technique to multiply the gains of an investment with the goal to get a higher return than it costs to borrow the money.
If leverage is used responsibly, you can be rewarded with positive cash flow and appreciation of the value of the asset. If you over-leverage a property, you have a higher risk of losing it due to changes in the market which may cause property values to go down or interest rate changes.
Example of using leverage to achieve a higher level of return:
You have $500,000 to purchase an investment property. Option 1 is to pay all cash for the property and Option 2 is to use leverage and finance a portion of the cost.
Option 1: Purchase Outright
You purchase a building for $500,000 in cash and that building produces $40,000 per year in net income. That income represents an annual return of 8%.
Option 2: Using Leverage
You put 20% down ($100,000) on a $500,000 property and borrow the remaining $400,000 at 6% interest. With the property earning $40,000 per year in net income, and your interest cost on the loan at $24,000 per year ($400,000 at 6% interest), your net investment return is $16,000 per year (income less interest). With your investment (down payment) at $100,000, you would receive a 16% annual return on your investment