Leverage, known to some people as gearing, it’s all about the use of debt financing. Specifically, debt financing is used in the act of structuring a deal for the purposes of commercial real estate investment.
Understanding how leverage works is important for making investments. It is also necessary for safely using leverage, as many investors don’t understand how leverage works and wind up making mistakes.
So, What is Leverage?
The basic explanation for leverage looks a little bit like this:
Imagine for a second that you have multiple sources of money. All these different sources of capital can be used to maximize the returns that you make on your equity. You can use these returns to get access to deals that would normally be inaccessible because of capital constraints.
Leverage is a tool that provides real estate investors with the ability to diversify, and they do so by taking their capital and allocating it to different investments.
Leveraging Investments
A lot of investors like commercial real estate because leverage is used frequently, but it’s a very secure way to use it.
Lending for commercial real estate investment is considered to be, financially, quite a stable and safe idea because the real estate market has a low level of volatility compared to other markets.
Because you can offer up real, physical assets for collateral when dealing with commercial real estate debts, investors have a chance to get returns that are relative to the amount of risk that they have contributed to the venture and then gain exposure, which can be used to apply leverage in a different place.
It’s probably worth noting that this debt, while often working in favour of returns, can be a problem in terms of compounding the loss. When we look at normal conditions in the market, the typical cost of the debt is lower than the returns that a commercial asset produces.
How to Use Leverage
Leverage can be a powerful way to increase returns within real estate investing projects. However, if you use it in a reckless fashion, it will backfire.
If you’re going to use leveraging the right way, then you need to make sure that you strike a balance between return and risk.
Trying to use leverage in this fashion demands a combination of skill and experience, and it is important to understand there is no one winning method for everybody.
An excellent way to try and cut your exposure to risk is to use a hedging such as the interest rate.
This is a special instrument that swaps one set of interest payments for another.
This usually takes place through a floating interest rate, trading it for a fixed interest rate. So, while the floating interest rate could be lower in places, you’re also removing the risk it could be higher.
By manipulating the level of debt consistency, you make investing a lot easier.
When you understand exactly how much you have to pay in terms of investments, it becomes much more sensible to try and make a proper investment in this fashion.
Final Thoughts
Leverage can be a powerful tool for an investor to use. It offers up a lot of benefits that can directly improve the chance of good returns but, if used without the proper experience, can backfire.
Understanding how leverage works and employing it successfully takes a little bit of practice, but it’s worth it. At the end of the day, by examining different types of leverage and utilizing the floating interest rate trick, you could successfully employ leverage in a range of different ways.
