After receiving the above form from a “financial professional" I thought it would be appropriate to write a post about leverage. By presenting me with this graph this professional was trying to show me that real estate was not a good investment when compared to funds, despite the fact that the average rate of return for those who invest in mutual funds for the last 10 years has been 1%. Without getting into the accuracy of the numbers presented in the graph for the last 23 years it failed to take into account the principal of leverage.
Leverage is using other people’s resources such as money in the form of a mortgage. In real estate you can obtain greater leverage then other forms of investing. This is achieved through using the bank’s money to pay for a portion of the property purchase in the form of a mortgage. The lending rules are different now then they where 23 years ago and you are required to have a down payment of 20% of the purchase price. The bank will lend you the other 80% so you are leveraging $4 for every $1 you have.
Why is this so important? When you consider the return on investment (ROI) for your money, leverage makes all the difference. Any appreciation the property has over the years is keep by you and the bank receives no appreciation for their portion of the funds used for the purchase. This can increase your ROI a multiple of 4 times.
Let’s say you have $200,000 to invest in real estate. If you purchase a $200,000 with all cash and no bank financing you have no leverage. If that house appreciated $50,000 over 5 years your ROI per year would be 5%. Now suppose you purchased the same house with a 20% down payment and 80% from the bank. With the same $50,000 appreciation increase over 5 years you now have a ROI of 25% per year. That is a huge difference.
Now I know you maybe thinking it is still a $50,000 profit either way so is there really any benefit? Well, since you only put down 20% and borrowed 80% from the bank you still have $160,000 left of the original $200,000. With that remaining $160,000 you can now go out and buy 4 more houses worth $200,000 since the bank will lend you the other 80%. Going back to the $50,000 in appreciation over 5 years your profit now goes from $50,000 to $250,000 and it was all achieved with the same $200,000 to start with.
Now you can see how inaccurate the graph I was presented was especially over a 23 year timeline.