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The Benefits of Leverage


How is it possible to get a greater return?

Minyan Amy writes:

I'm sure you know that as an "investment", real estate returns 1% over inflation based on about 100 years of data. That means, from your example in A Decade in Flux: The State of the Markets -- "simply adjusting for inflation and ignoring all other factors, a house bought in 1965 for the median price of $17,200 would cost $118,123 in today's dollars. With the current median price just over $200,000, that means more than half of all home price appreciation in the past 45 years can be attributed to inflation" -- houses currently at $200,000 should be about $125,000, which is why I'm sitting and waiting for the big banks to go through meltdown number two. The bubble is still quite big, although direction is correct.

Yes, I've seen data like that, but do you know if the data you mentioned includes leverage (i.e. a mortgage)? Because even if your home only appreciates 2% in a year, in line with inflation, if you only put 20% down your actual return on equity is a lot higher.

Don't get me wrong, I think you know I'm not in the "real estate always goes up" camp, but since nearly all real estate is bought with leverage, it should be considered.

Minyan Amy:

I've always been interested in the idea that the return is greater when using leverage because I have to admit it doesn't always make sense in my brain.

If we assume more "normal" interest rates of 6%, how is gaining 2% on an uninsured investment over time putting you in the black? My very rough calculations suggest a loss of 4% per year.

Ignoring the effects of inflation, a mortgage quadruples (at least) the initial cost of a house. Real estate is an odd duck in so much that you have to live somewhere, so it makes sense to take out a mortgage if you're staying in place for a while and mortgage payments are cheaper than rent. Almost every other purchase can be delayed until cash is at hand except for real estate.

Since it's hard to do tone in writing, this really is a serious question. I always feel like there's some huge piece I'm missing when leverage is pointed out. I'm really hoping you have an example so I can have an "ah-ha" moment.

Leverage is as simple as it is complex. Here's a simple example that tries to illustrate the benefits of leverage (when employed correctly of course).

Let's say you buy a house with cash for $300,000. You're pretty savvy right, so you sell it in 12 months and net $400,000 after broker commissions and transaction fees -- a cool $100,000 profit, or 33%. Now let's assume you had borrowed 50% of the original $300,000 and paid 10% interest on the money. Since you put up just $150,000 in cash rather than $300,000, your cost basis went down considerably. After 12 months you sell the property and have to pay $15,000 in interest ($150,000 times 10%) so your profit goes down to $85,000. But because the denominator of your return calculation went down, your cash on cash return goes up. $85,000 divided by $150,000 is 56.7%.

Of course, that's if things go well.

Same scenario, but you make a lousy deal and only eek out proceeds of $310,000 after commissions and fees. Buying with cash you make just 3%. If you had bought with leverage, you'd still have the interest expense so you'd actually lose 3%.

When you make even worse bets, the numbers look even worse. (You're beginning to see why we are where we are, eh?). If you can only net $250,000 on the sale, you lose 17% in the all-cash scenario. ($50,000 loss divided by $300,000 investment). With leverage, you lose $65,000 ($50,000 loss plus $15,000 interest expense) and with the smaller denominator you actually lose 43% ($65,000 loss divided by $150,000 investment).

And finally, if you were so lucky as to have gotten 95% leverage at 10%, you only put up $15,000 into the deal. If you sell the property for a loss of $50,000, that plus your now greater interest expense of $28,500 makes your loss a whopping 523%. Oops.

So, moral of the story? Leverage can increase your returns, but it magnifies the losses more. It all has to do with what your cost basis on the investment is compared to the return. If your return percentage is greater than the cost of your leverage (i.e. interest rate plus fees), then leverage is a benefit. But if your return percentage is lower than your cost of leverage, well, we know how that ends up.
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