On the surface, real estate is a terrible investment. With rental properties you have to deal with tenants, vacancies, maintenance and repair, insurance, taxes and so on. It is definitely high maintenance when compared to stocks, bonds or other investments. The rate of return isn’t so great either. If you pay $100,000 for a property that rents for $1,000 per month, or $12,000 per year, it doesn’t look so bad. But what about all of those expenses? That can easily consume 40-50% of the rent each month. Now your return may be down to about 6% of the amount invested.
You do get some tax benefits such as depreciation. But depreciation is recaptured when you sell so, at best, it is a temporary advantage. All of the other deductions just mean that you lost money and are allowed to use the loss to offset income, is that really an advantage? Surely there’s appreciation, right? Appreciation is a bonus, not a right. What if the real estate market doesn’t appreciate (article) for a very long time? If you look at the long-term appreciation of real estate you will find that it, for the most part, mirrors inflation. So why would anyone invest in real estate? Leverage.
Cash Purchase – $100,000
You will also have net income assumed at $550/month (today’s dollars)
Total gain = $34,392
Income = $66,000
Total = $100,392
Leverage Purchase – $400,000
Value in 10 Years – $537,567
Mortgage Balance – ($274,600)
Income = $0 (income used to pay mortgage)
Net Gain = $182,967 (includes principal reduction of mortgage)
In the cash purchase you doubled your money in ten years with a combination of income and appreciation. The total return was $100,392 over the ten-year period.
In the leverage purchase you used the same money to obtain a total return of $182, 967. That’s over 82% more using the same amount of money to start. Of course, there are all sorts of variables that can affect the return, this example is just being used to illustrate a point.
The Dark Side
As the recent collapse of real estate prices has shown, leverage is a double-edge sword that cuts both ways. Just as profits are magnified, so too are losses. If we use that same $100,000 house as an example and assume a 25% drop, it is easy to see the harm in using leverage. If you pay cash and the price drops 25% you still have 75% of your investment. On the other hand, if you purchased with a 25% down payment and suffered a 25% price drop, your entire investment has been wiped out.
The overuse of leverage is what caused the housing bubble in the first place and also what led to its ultimate collapse. When used wisely leverage is a powerful tool. Used incorrectly it can be devastating.
Give me a lever long enough and a fulcrum on which to place it, and I shall move the world. – Archimedes