This is a guest post by Owen Johnson.
Part 5 in a series of 7 on real estate.
THE WEEKLONG SERIES OF REAL ESTATE BASICS
1. The Real Scoop on Real Estate
2. Starting Down the Real Estate Investment Path
3. The Transaction Mechanics
4. A Primer on Real Estate Agency
5. Leveraging Yourself to Grow Your Wealth
6. Management Infrastructure
7. The Week in Review
What is leverage?
Ah, leverage. The not-so-secret sauce that enables real estate to have such wonderful returns. I’ve mentioned before that the equities equivalent of putting a mortgage on a property is trading stocks on margin. In both cases, you are getting a loan and backing it with assets. Should those assets go down in value too much, then the entity loaning you the money will call the funds or in other words, force you to pay them back, potentially liquidating the assets backing the loan at a bad time. Sounds scary, doesn’t it?
Well, it is and it isn’t. Unlike stocks, which can drop significantly in value over short periods of time, real estate tends to change value in years or in extreme markets like we live in today, in months. As well, in most cases, it’s much easier to sell a stock than sell a house.
These two differences as well as a few others lead to leverage in the real estate world being a commonly used tool.
How is it done?
Because leverage is so common in the real estate world, there exists an extremely elaborate system to support it. Banks, mortgage companies, and other lenders provide loans to individuals and in exchange place a mortgage on the property that must be paid before the property is sold.
Why is leverage so magical?
Let’s start by imagining that you have $10,000 and you want to buy a $100,000 house. Well, as we all know, rarely does one find a deal where you can buy something worth $100,000 fo $10,000, so what do you do? That’s right, you get a loan!
So, what that means is that you just spent $10,000 and you now control an asset worth $100,000. If that asset’s value goes up in value 1%, that’s $1,000, which is 10% of the money that you put into the deal. If the asset’s value goes up 5%, that’s $5,000, or 50% of the money you have in the deal or in other words 50% return on investment(assuming you sold the asset with no sales costs).
So, leverage is just at tool that allow a small amount of money to control a more highly valued asset, thereby turning small appreciations in value into larger returns on investment. The reverse is also true, which is why leverage increases the risk of an investment.
The Catch and the Solution!
Just with everything in life that appears too good to be true, the same goes for leverage in real estate. It’s a very good thing, but there is a catch – you have to pay for that loan every month. If you personally pay for that mortgage every month, then your returns vanish very quickly. *this is the reason that a house that you live in is typically not a good financial investment!*
That’s why it’s critical to use the asset you have purchased to produce a cashflow that will pay for your mortgage. In the case of a house, you could rent it to tenants. In the case of land, perhaps you can timber the land and use the money to slowly pay the mortgage payments over time.
Every asset type is different and has different possibilities, but no matter what you are buying, make sure to do the financial analysis and sanity check the assumptions that you are making. You do not want to be paying back the loan that you used to buy the property, you want to let the asset do that for you.