Leverage: Friend or Foe?

by | BiggerPockets.com

On the surface, real estate is a terrible investment. With rentalcg99 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.

More Bang For The Buck
By using leverage in the form of a mortgage you are able to control an asset that is several times larger than the amount invested. This will magnify your return. You will give up immediate cash flow since that money will now be used to repay the loan. However, some of that payment is used to reduce the loan balance and the loan could eventually be fully paid off if you own the property long enough.
Let’s try an example. We will compare a single cash purchase for $100,000 against the purchase of four homes with for $100,000 each with a 20% down payment with 5% for closing and other costs. Mortgage is assumed to be at 7% for 30 years. Appreciation will be assumed at 3% for ten years.

Cash Purchase – $100,000
Value in 10 years – $134,392

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


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1 Comment

  1. Well said, but given the alternatives in this climate any cash on cash return in excess of 5% is outstanding and given the still stable markets with appreciation the internal rate of return can still be approaching double figures. Plus you own a “tangible” asset not paper which has value only to the Boardroom. Also assuming your hard costs are fixed ie. Mortgage, Taxes with rent escalators your returns continue to grow. And opposed to selling stocks where you just pay the taxes you can defer via 1031.

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