Leverage and Real Estate
Leverage is defined generally as the use of something to gain ease, advantage, or power.
In the finance world, leverage is more specifically defined as the use of borrowed funds to gain proceeds, from an investment, greater than the cost of those borrowed funds. A simple example of this is if you borrowed money from a bank to start a business, and you were able to make the business make more money than it costs to pay back the loan, you would be leveraging the bank’s funds to make proceeds for yourself.
To me, the fact that a bank will loan you money against your real estate investments (leverage) is the biggest advantage over any other investment there is. A bank won’t loan you money to buy stocks, crypto, life insurance, or any other type of investment that I am aware of. Try it out - walk into a bank and ask them to loan you money to buy shares of that bank’s very own stock. They won’t do it. However if you ask them to loan you money against real estate, they will gladly do that - provided of course you meet the bank’s qualifications and have a down payment.
But think about this - if you brought a down payment of $100k into a bank, and you have good enough credit and can show sufficient rental income in the property in question, they will typically loan you at least 300k against the investment property. So that’s a total purchase of an asset worth $400k, but you only had to bring $100k of your own money. This is the essence of leverage.
Why is this such an advantage?
It goes like this. You could take your $100k and put it into the stock market. Maybe your investment manager says he can make you 7% per year on this investment (which includes appreciation of the stock value and any dividends). So the first year that’s $7,000 return on investment.
But let’s say you used that $100k for a down payment and bought a property that was worth $400k. Because of leverage, you now own an asset that is increasing in value at the $400k value. If you can increase the value of that property by 7% per year (with the right investment, this is easily attainable), 7% of $400k is $28,000.
Now since it’s real estate, you will additionally have rental income that will exceed your mortgage, taxes, insurance, and any other expenses (also known as net profit). Without getting into too much detail, if you got a decent investment, you would conservatively make 4% of your $100k investment in net profit from the cash flow of the property. That’s another $4,000 per year that you actually get to put in your pocket on a monthly basis.
So because of leverage, in the real estate investment example you increased the value of your $100k investment by $28,000 - which is actually 28% of your investment - and you got $4,000 in your pocket. That’s a total of $32,000 compared to the $7,000 you got with the investment straight into the stock market.
