The Benefits of Leverage
How is it possible to get a greater return?
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.
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.
The information on this website solely reflects the analysis of or opin=
=3D =3D3D ion about the performance of securities and financial markets by =
the wr=3D iter=3D3D s whose articles appear on the site. The views expresse=
d by the wri=3D ters are=3D3D not necessarily the views of Minyanville Medi=
a, Inc. or members=3D of its man=3D3D agement. Nothing contained on the web=
site is intended to con=3D stitute a recom=3D3D mendation or advice address=
ed to an individual investor =3D or category of inve=3D3D stors to purchase=
, sell or hold any security, or to =3D take any action with re=3D3D spect t=
o the prospective movement of the securit=3D ies markets or to solicit t=3D=
3D he purchase or sale of any security. Any inv=3D estment decisions must b=
e made =3D3D by the reader either individually or in =3D consultation with =
his or her invest=3D3D ment professional. Minyanville write=3D rs and staff=
may trade or hold position=3D3D s in securities that are discuss=3D ed in =
articles appearing on the website. Wr=3D3D iters of articles are requir=3D =
ed to disclose whether they have a position in =3D3D any stock or fund disc=
us=3D sed in an article, but are not permitted to disclos=3D3D e the size o=
r direct=3D ion of the position. Nothing on this website is intende=3D3D d =
to solicit bus=3D iness of any kind for a writer's business or fund. Mi=
ny=3D3D anville mana=3D gement and staff as well as contributing writers wi=
ll not respo=3D3D nd to em=3D ails or other communications requesting inves=
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter