How Leverage Can Multiply Your Returns & Create Massive Wealth, Part 1

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The word leverage has different definitions and has slight nuances depending on the context it’s being used in. I’d like to talk about it in this particular post in terms of real estate investing. In this case, leverage means to use borrowed capital to increase the return of your investment. To many of you that might sound scary, but if you’re a homeowner, you’re likely using this very thing.

Leverage – Use borrowed capital to increase the return of your investment

Most people I know don’t buy a home outright in all cash. (Wouldn’t that be nice though!) Instead, they usually put down a down payment (20%) and borrow the rest (80%) from a bank to acquire an asset (your home). You plan on paying the mortgage over time and I’m sure all of you hope that it will increase in value over the years. The amount of gain is a direct result of appreciation & leverage.

So in other words, leverage is a powerful tool that allows a smaller investment to control an asset that has a higher value. Therefore, small appreciations in the value of the investment result in much larger overall gains.

So, how can it make you wealthy? Well, it can magnify your returns tremendously.

Here’s a basic example to illustrate this concept and here are the set of assumptions in this model:

  • I’m using the widely accepted 10% average annual stock market gains, compounded annually
  • I’m using 5% appreciation in national average home value (this value differs from 4-6% depending on your source)
  • Not factoring in inflation or taxes
  • In purchasing the investment property, it is one where the tenant covers the expenses involved (mortgage, taxes, insurance, maintenance, etc.). Not hard to do, as referenced here.
  • Even though tenants are paying off the debt, I’m keeping the original debt amount the same to make calculations easier. In reality, the debt would be slowly paid off and diminish, adding to the investment property’s equity.

If you had $100,000 to invest completely in the stock market, this dollar amount purchases a set amount of shares equaling this value. Forgetting the transaction fee, at that current moment, your $100,000 buys you shares of stocks worth exactly $100,000.

Now let’s say instead you purchase an investment property that’s also worth $100,000. However, in this case you’re able to take out a loan on the property and put a down payment of 25% ($25,000) with the bank lending you $75,000 to purchase it. You now control this $100,000 asset using $25,000. This an example of simple leverage.

Continuing on, let’s say the value of both assets, stocks and investment property, both grow at their expected growth / appreciation rate. What are you left with after a year? Let’s take a look:

Stocks Real Estate
Purchase Price 100,000 100,000
Investment Amount 100,000 25,000
% Annual Gain 10% 5%
Value of Investment after 1 year 110,000 105,000
Gain in Value 10,000 5,000
% Return on Investment* 10% 20%

*Your return on investment is calculated by taking the gain in value divided by your initial investment.

You can see that even though your % annual gain in real estate is half that of stocks, your overall % return on investment can be double because of the use of leverage.
Now let’s extrapolate that over 5 years with gains compounded annually. You can start to see how leverage makes a tremendous impact.

Stocks Real Estate
Purchase Price 100,000 100,000
Investment Amount 100,000 25,000
% Annual Gain 10% 5%
5 Year Value of Investment 161,051 127,628
Gain in Value (subtract debt) 61,051 27,628
Overall Return on Investment 61% 111%

To make it even more interesting, at the initial time of purchase, instead of just using $25,000, you used the same $100,000 you would’ve used purchasing stocks, used it as a down payment (25%) and using leverage purchased a property valued at $400,000. Well, here’s what that looks like after one year:

Stocks Real Estate
Purchase Price 100,000 400,000
Investment Amount 100,000 100,000
% Annual Gain 10% 5%
Value of Investment after 1 year 110,000 420,000
Gain in Value 10,000 20,000
Overall Return on Investment 10% 20%

Here is what it could look like after 5 years.

Stocks Real Estate
Purchase Price 100,000 400,000
Investment Amount 100,000 100,000
% Annual Gain 10% 5%
5 Year Value of Investment 161,051 510,513
Gain in Value (subtract debt) 61,051 110,513
Overall Return on Investment 61% 111%

Hopefully those gains looks impressive to you even with half the annual % gain of stocks. It definitely does to me.

Here’s a personal example of leverage at work:

I purchased my own home 5 years ago. The value of my home has doubled because of the “hot” market I live in. I put a 20% down payment on the home. Because of leverage, my return didn’t just double (like the home did) but in fact resulted in a 500% gain in 5 years and a 43% annualized return. The first $500,000 of gain would be tax-free if we sold, which in my tax bracket is huge! However, to realize these gains, I’d have to sell and move, but I won’t yet based on what I wrote here.

Caution

Photo Credit: Denver Public Library

Just a word of caution though, leverage can be a two-headed beast where you can multiply your gains but can also multiply your losses in case you have to sell. Personally, I like to use leverage for my real estate investments. I don’t purchase them all in cash. However, I try not to over-leverage them meaning that if I lost some tenants, I could cover the debt service and not risk losing everything. That’s how so many people lost it all during the economic downturn of 2008. They owned a lot of investments in addition to their personal homes, couldn’t cover the debt service or mortgage, and ultimately ended up losing their entire investments.

Summary

Debt can be scary but it can also be a powerful tool when used in the right manner to accumulate wealth. I suggest a balance – don’t be so scared of leverage that you don’t use it to your advantage, however, don’t over-leverage to the point that you couldn’t survive a dip in the economy.

10 COMMENTS

  1. This is a great, simple explanation of leverage. After “leveraging” medical school and going nearly a half million dollars in debt, I am very reluctant to use leverage on anything from now on. I plan on (eventually) purchasing my first rental property with cash. However, as you explain, this will limit my returns.

    • “Leveraging med school” haha… The benefits of purchasing that rental property with cash is great because it maximally cash flows from day one and you don’t have to go through the crazy loan process. However, it might take you a little longer to accumulate that cash, and you’ll miss out on some tax benefits and likely some years of appreciation. Either way, love that you’re thinking about investing in real estate!

  2. My husband and I feel like same way as you. We don’t dread work but the financial freedom to have more control would be spectacular.

    This post makes me feel a lot less anxiety about our underwater rental :). I did the math over and over before we purchased and we should be able to hold up both of our properties if the sky were to fall like in 2008… it’s going to hurt big time, but we can. And both short term rentals are currently generating income to break even (even a tiny profit) a year which is amazing even if you don’t count the appreciation.

    Can’t wait for part 2!

    • Being able to break even with a recently acquired property in your area is not an easy thing to do. Most people have to put down a significant down payment to make that work. So that’s awesome… I’ve explored the idea of short term rentals and will probably lean on you guys for some advice if I ever do decide to do it. You’re way ahead of most people in your situation and looking back 15-20 years from now, I think it’ll be way worth the stress you feel now.

      • Feel free to shoot me any questions if you guys want to explore that avenue! I’ll try my best to give a helpful answer. I like to keep a hawk eye on my local real estate trends and the inventory trends for each asset class (single family, condo, commercial etc.) I recommend that for anyone interested in investing in real estate. And I’m not the type to trust a real estate agent to do that for me hehe.

        • I may call you on that soon… Harder to find a good real estate agent that understands the investing side in depth, but if you do, they’re worth their weight in gold. The problem is if you’re not willing and ready to jump, you may not have first crack at anything they find.

  3. Leverage and pro-homeownership tax policies have been my best, best friend. It is crazy. I was going to sell one of my homes in 2012 when I left Corporate America to shore up liquidity, but decided to hold on. 2012 turned out to be a low in pricing, and now prices are up 68% since. CRAZY! I’m taking chips off the table b/c I bought another house in 2014, also with leverage while keeping my old house.

    I want more peace of mind as a retiree now.

    Sam

  4. Shouldn’t you add your mortgage payments each year to your total “investment” when you calculate the return. You had to put in more than $25k after one year. And after 5 years, you’re in for the $25k plus 5 years of mortgage payments.

    Oh, wait. I guess you’re saying that your renter covers the mortgage payment each month.

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