Don't Forget the Leverage Factor in Real Estate

Leverage is all about using "other people's money" to leverage your own investment.  Other than big-time leverage deals on Wall Street, the common individual has few opportunities to leverage. But real estate is one of those areas.  It is one of a very few areas where you can borrow money from a banker to cover the majority of the total cost of an investment.  The leverage part is that if the value of the property goes up over time, you gain from the increase in value of the entire property; not just the increase in the value of your down payment.

Obviously, you need good credit in order to benefit, particularly these days when mortgage loans are evaluated more closely than they were in 2004 through 2008.  Also, the idea of leverage only works if values increase.  Thousands of people have been harmed over the last three years because of decreasing home values, but many people now believe values may have bottomed-out.  This is certainly true in some areas of the country, while not true in others.  So be sure to evaluate your own market before jumping in.

This is how leverage works:

In scenario #1, let's say you invest $50,000 as a down payment on a $250,000 house.  Let's also assume that the value of your property increases 5% per year over 5 years.

In scenario #2, you invest that $50,000 in XYZ Widget Company.  Widget Company is successful over the next five years and the stock increases in value 5% per year.

In five years you sell XYZ Widget Company at a value of $63,814.  That is a very nice $13,814 profit.

On the other hand, you sell the home after 5 years and it has increased 5% per year during that time.  The house sells for $319,070.  This translates to a profit of $69,070, plus the increase in equity that you have gained through making your mortgage payments.

Investing $50,000 in a non-leveraged investment like XYZ Widget would give you a 28% return.  Investing in a home with the same investment would give you a return of 138% return.  Wow!  Also, keep in mind that you benefit from tax deductions for your mortgage interest and taxes, which increases your return even further.

Is Home Owner Leverage for You?

We have learned the hard way that home ownership is not for everyone.  Credit worthiness and stability of household income is essential before buying a home -- or a second home.  But if home values are at their lowest level in 5 years, mortgage interest rates are low, and you believe property values will increase over the next 3 to 10 years in your area, thinking about the leverage available in real estate might be the compelling argument to move forward.