LEVERAGE ADVANTAGE

\ Why Real Estate \ Leverage Advantage

Leverage is probably the largest differentiating factor that sets Real Estate investments above other investments. Because of its proven history for long term appreciation and security, there are multiple banks/lenders that will gladly give a loan of 80%+ on a well selected piece of property. What makes leverage so powerful?
A few basic examples are as follows:

Example 1:
House Purchase – cash versus loan
House for sale $200,000

A) No Leverage:

Investor A purchases house with $200,000 cash
House appreciates 5% in one year.
Investor A sells house for $210,000 ($200,000 x 1.05).

Profit = $10,000 (sell price – purchase price = $210,000 - $200,000)
Return on Investment (ROI) = 5% (profit/initial cash investment = $10,000 / $200,000

B) Leveraged:

Investor B purchases house with a conventional 20% down payment ($40,000 down, $160,000 loan)
House appreciates 5% in one year.
Investor B sells house for $210,000 ($200,000 x 1.05).

Profit = $10,000 (sell price – purchase price (assuming no mortgage pay down) = $210,000 - $200,000)
ROI = 25% (profit/initial cash investment = $10,000 / $40,000

As seen from the example above, the profit of investor A is the same as investor B, but the ROI of investor B is 5 times that of investor A's. Now, if investor B were to invest the same initial amount of cash as investor A, he could purchase $1,000,000 worth of property and substantially increase his profit.

Example 2:
Stocks/mutual funds versus Property returns

A) Investor A buys $20,000 worth of stocks/mutual funds. Shares go up 15% in one year.
B) Investor B uses the same $20,000 for a conventional down payment to purchase a $100,000 rental property.. House appreciates 5% in one year.

Which investment performed better?

Investor A:
Profit = $3,000 ($20,000 x 1.15 = $23,000, $23,000 - $20,000 )
ROI = 15% (3,000 / 20,000)

Investor B:
Profit = $5,000 ( $100,000 x 1.05 = $105,000, $105,000 - $100,000)
ROI = 25% (5,000 / 20,000)
(Example includes equity appreciation only. Doesn't include positive cashflow or mortgage paydown)

As seen from the above example, the rental property provided better returns than the stocks/mutual funds with only a 5% increase compared to 15% on the shares. In fact, the rental property, assuming break even cashflow and no mortgage paydown, would only need to increase by 3% in order to provide the equivalent returns provided in shares increasing by 15%. This is the power of leverage!