The Power of Appreciation and Leverage: Boost Your Real Estate Returns
If you’ve read any of my blogs on BiggerPockets, you’ve probably noticed that I am a believer in real estate appreciation. Yes, real estate can and has lost value in recent years; but over time, real estate generally increases in value. This is especially true if you happen to time the market effectively. I have not been shy about the fact that I believe now is a very good time to buy investment properties. With certain markets at historically low prices and interest rates also at historical lows, it doesn’t take a crystal ball to determine that now is probably a good time to invest in real estate. Just watching the dynamics in my own market and the upward pressure on prices, I have no doubt in my mind that investors have an unbelievable opportunity to buy low and ride a wave of rising values over the coming years.
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While most investors today care solely about cash flow, I can’t help but talk about the potential for increasing values. Cash flow is absolutely fundamental to a long term real estate investment, but one of the most powerful principles behind real estate investing is the combination of leverage and appreciation.
Real Estate Leverage & Appreciation Explained
New investors may be asking the question, “What do you mean by leverage?” Simply put, leverage is a term used in real estate (or any type of investing) to describe the effect of borrowing money to purchase an asset (i.e. property). It’s the idea that you can buy a $100,000 property by investing only $20,000 of your own money. You are essentially “leveraging” somebody else’s (i.e. the bank’s) capital to buy the property.
When you combine the ability to use leverage in real estate with appreciation, you have an unbelievable money making combination. Let me illustrate with the example below (For the sake of this example, I’m going to leave out any cash flow calculation):
Let’s say you are able to buy an investment property for $100,000. Over the course of 5 years, the property increases at a rate of about 6% per year so that in year 5, the value of the property is worth approximately $134,000. Most people would nod their head and say 6% per year on an investment is fairly respectable.
However, if you are able to buy this property with leverage, your true return actually looks a lot better than 6% annually. Let’s say in this example you put 20% down or $20,000 to buy the property. Your $20,000 investment actually made an additional $34,000 (134K-100K) over the course of just 5 years. That’s approximately a 22% annual return for each of those 5 years! Why? Because while you only had $20,000 invested, you had the benefit of the entire asset increasing in value, not just the dollars you had invested.
(And again, this example doesn’t even include the returns generated by renting the property!)
It’s been reported that over 90% of millionaires made their money in real estate – this is why! I know this is a simple concept, but it’s one of the reasons that real estate investing is so powerful. Living in the United States, we have unbelievable access to financing as well as an abundance of properties. All of the tools to build this kind of wealth are at our fingertips if we just take a little initiative.