Ever hear someone say “leverage enables you to make money off other people’s money”? This is one statement that perfectly captures the power of leverage in real estate investment. You not only get to play with your own money but also that of your lender. Subsequently, if your property goes up in value by say 5%, your return on the initial investment goes up by much more than 5% (up to 100% if you only put in 5% in the first place). Likewise, if the value of the property goes down by 5%, you will lose much more than 5% of your initial investment.
What is a leveraged investment?
Being a property owner isn’t exactly a gold-laced path. Making a purchase involves a lot of capital investment, and you need money to make money. How then can you get launched into the real estate market with a relatively small amount of money?
One word: Leverage.
In investment lingua, leverage is the use of financial instruments or borrowed capital to increase the potential return of an investment. Leveraging can help you get an ROI that’s a couple of times higher than the underlying price movement. At the same time, the risk is much higher since if the value of the underlying investment drops, you also lose much more money.
How does leveraged investing work?
Let’s use a common case study: buying a home. Let’s say you bought a property worth $500,000, made a down payment of 20%, or $100,000, and borrowed $400,000 to pay for the rest. The real estate market is booming, and in a few years your $500,000 home is now worth $600,000, an increase of 20%. If you sell your home, you would get $600,000 – $400,000 (the amount you borrowed), leaving you with $200,000. This would have given you an ROI of 100% from your initial investment of $100,000, and is, proportionally speaking, 5 times more than the absolute change in the value of the property. In reality, your return would be lower than this due to the costs involved with buying and selling a home as well as financing your mortgage, but you get the idea.
How much power does leverage give you?
In principle, leveraged investing is straightforward, but in practice, it’s more difficult to grasp. How powerful is leverage, really? Let’s say you’re a real estate investor with $100,000 to invest. How could you use your money? You could:
- Buy a property worth $100,000. If you use this approach, you aren’t borrowing any money and your leverage factor is one. If the property’s price rises by 10%, the value of your investment rises by 10%. If the property’s price drops by 10%, the value of your investment drops by 10%.
- Borrow $100,000 to buy a property worth $200,000. This gives you a leverage factor of two (you’re staking double your initial investment). If the property’s price rises by 10%, the value of your investment rises by 20%. If the property’s price drops by 10%, the value of your investment drops by 20%.
- Borrow $400,000 to buy a property (or properties) worth $500,000. This would give you a leverage factor of five. If the price of the properties rises by 10%, the value of your investment rises by 50%. There’s significant risk at high leverage factors, however, as a decline of only 20% in the value of your properties would zero out your entire investment.
Covering the ongoing costs of owning a property
Whenever you borrow money, you’ll have to pay interest and may have to make regular payments on the principle, such as in the case of mortgages. This means you can’t just count on long-term property price appreciation – you need regular cash flow to make your loan payments. Most landlords choose to rent out their properties to get a source of regular payments for their mortgages. In a previous post titled “Is Renting a Waste of Money?”, we offered an in-depth analysis of how the costs of renting a property (or the revenue from renting out a property) often match up with the costs of owning the property. Whether or not renting out your properties is truly profitable will depend on the specific real estate market you’re in, but it’ll still be better than leaving your property empty and unused.
A real-world analysis of post-leverage ROI
A precise calculation of the ROI on a leveraged property investment can only be made after considering factors such as the property operational costs/income, mortgage interest and other financing costs, and the costs of buying and selling the property.
Let’s start with a $500,000 property with a $100,000 downpayment and a $400,000 mortgage. In our previous article, “Is Renting a Waste of Money?”, we explained how the amount of money you earn from renting out a property, or the amount of money you save by living in the property, is roughly equivalent to your downpayment times your mortgage interest rate . Over the course of 5 years and assuming a mortgage rate of 3%, you would earn/save $15,000.
Let’s say at the end of those 5 years, your property’s price is now $600,000 (an increase of 20%, or only 5% per year) and you decide to sell. Selling costs, including real estate agent commissions and regulatory fees, would be around 4.5% of the market value of the property, or $27,000. Your total profit would then be the property price appreciation ($100,000) plus the amount you earned over the 5 years ($15,000) minus the costs of selling ($27,000), or $88,000. Compared to your initial investment of $100,000, this gives us an amazing 88% ROI over the course of 5 years.
A smart real estate investor understands the power of leverage, and how to take advantage of it. Make sure to finance at the lowest mortgage rates and find the right markets to invest in, and you too can use leverage to multiply your investments.
: This was based on real market data that showed that combined costs of owning a home, including property taxes, condo fees/maintenance fees, and mortgage interest, were roughly equivalent to the market rent of that home (assuming you borrowed 100% of the value of the home). In that case, any downpayment you make effectively saves you the interest you would have had to pay on that amount, “earning” you money.