The Power of Leverage
This one concept is what makes real estate an incredible way to build wealth. Leverage is a very important concept for becoming a property gangster. There’s gonna be a little math here but don’t worry as long as you understand the general principle that’s all that’s needed.
Example without leverage
Lets say you have 100,000 to invest. You find and purchase a house for that amount and rent the house for 1000 per month. Lets say you bought in a highly sought after area and your property appreciates 10 percent per year.
Lets also say your rent is about to increase the same amount. So after 1 year the property is now worth 110,000 and your rent is 1,100 monthly. After 1 year you made out good and the future never looked better, right?
To make the math simple let’s suppose in 15 years your property has appreciated 10% per year. Math that shit up and you get a house worth 250,000 after that 15 years. Are you with me?
Lets now say your identical twin had the same 100,000 to invest but instead found a property worth 500,000 to investing in. He used his 100,000 as a down payment and borrowed the rest from the bank. Using the same appreciation in year one his building is worth 550,000. He made 50,000 in year one instead of 10,000. After 15 years his building is worth 1.25 million.
Disclaimer: Don’t pick apart my math I know I left out a lot of details. Its a generalization to make a point about leverage.
This friends, is the power of leverage. Sometimes its not what you own free and clear but what you can control. Using leverage to control a property that you otherwise could not afford you eventually reap the rewards as if you had paid for the property in full.
This is how someone can start with nothing and become a self made millionaire in his lifetime. The power of leverage.
Want to compare Real Estate to Stocks? Good luck trying to put down 100,000 and borrowing 400,000 in order to buy 500,000 in stocks. Not gonna happen, same with gold or just about any other investment class.
There was a third twin! Illigitimate of coarse, but none the less. This red headed twin decided to invest in the stock market. Between 1926-2018 stocks returned 8-10 percent. At 10 percent the stock market returns the same as example one where we paid cash for the property.
Here again, I have made some huge simplifications to the math but any way you look at it using leverage is gonna be the fastest way to build wealth. Which example looks best to you? 250,000 after 15 years or 1.25 mil?
To be fair, part of the math that was left out is the monthly cash flow. In example 2 there is a loan which will require a monthly payment and interest expense.
In example one, the rent collected is 1100 monthly in the first year and there’s no payment so its all free and clear. In example 2, using the 1% rule, monthly rent in the first year will be 5,000 monthly. As long as you get your financing using the proper amortization you should be able to structure your payments for 3900 monthly. In this case, the monthly cash flow will be exactly the same for example 1 and 2.
Do you see the writing on the wall? All things being equal the leveraged investor outpaces the non leveraged investor 10 out of 10 times!
I would be doing the reader a disservice if I didn’t admit that there are some people who do well in real estate that do not use leverage in the same way. The most impressive that I know of is Rich from the blog “Rich on Money“. Rich has 20 properties paid for free and clear and thats what works for him. He feels comfortable not leveraging.
In closing, I want to point out that my portfolio is probably valued at 5 million but I only invested about 500,000 to get there. Leverage has clearly been the deciding fact in my journey.