Here is your quick tip for the day: Among all the benefits real estate provides for investors and owners, I believe one of the most important and valuable ones is the use of leverage and how it impacts your ultimate returns.
Using debt to buy real estate is an accepted and very common practice. Many loans are in fact backed by the full power and authority of the US Federal Government and as of last check, the federal government now invests in or insures over 90 percent of mortgages in the U.S. via Fannie Mae, Freddie Mac or Ginnie Mae.
So, what’s the big deal about leverage?
Let me illustrate the power of leverage – We will perform a simple investment comparison between an all cash purchase of a property and one purchased with a loan (with “leverage”, i.e. you are buying the whole asset but are able to use the banks money to pay for the majority of the purchase by only providing a down payment to secure the property and the loan).
Scenario: You wish to purchase an investment property worth $500k today. You expect that over the next 5 years the value will go up a total of 10% (~2% annually).
If you purchase with cash:
- Purchase price: $500k
- Capital invested: $500k
- Profit: $50k (10% of the purchase price)
- Total Return = $50k/500k = 10%
However, if you purchase with leverage:
- Purchase price: $500k
- Capital invested: $100k (20% down payment vs. the entire purchase price; rest financed with a mortgage/loan)
- Profit: $50k (the property still goes up only 10%)
- Total Return: $50k/100k = 50%!
This lets your investment dollars go farther. Since you only put down a portion of the total sales price, for every increase in the value of the overall asset, that grows at a significantly larger factor than the initial leveraged capital that went in to begin with.
