In the past year, my rental property had a modest 4% of appreciation. That’s in line with the historical average for that region, and surely a return that you could easily beat with an S&P500 Index Fund.
Except I actually beat the stock market with a whopping 20% return from appreciation alone.
How? The secret is in using Real Estate Leverage.
What is Real Estate Leverage?
Leveraging Real Estate is to borrow other people’s money to make your return much more attractive.
- If we use it correctly, it offers the opportunity to multiply our returns to 20%+ ranges very easily.
- If we use it incorrectly, it will break our bank (*cough* 2008 *cough*).
Taking a mortgage to buy a home is a widely known concept and most of us will probably have to do it at least once, right?
What you might not realize is that home mortgages are the most famous way of leverage there is.
Taking a traditional home mortgage means we’re putting 20% of our own money, borrowing 80% from the bank and controlling 100% of the home.
- You put 20% out of your pocket
- The bank puts 80% out of its pocket if you promise to pay it back with interest (a loan).
- You now buy and control 100% of the house
That’s Real Estate Leverage. To control 100% of the home with a smaller portion of your money.
That’s also why so many homeowners see their houses as their best investments. They look at the long-term appreciation potential working with leverage for fantastic returns.
I personally don’t think of homes as an investment, but Rental Properties on the other way make for great investments and they work wonders with leverage.
Leveraging Real Estate Investments
Excellent rental properties bring enough income every month to cover not only the mortgage payments but also all related expenses and still produce a positive cash flow left.
I’ve written about the math behind it in How to make money with Rental Properties.
There’s primarily two types of return with rental properties:
- It generates monthly income in the form of rent
- It appreciations over time
Let’s take only the appreciation to quickly get a sense of how leverage works in Rental Properties.
If we consider a modest 4% appreciation and that we’re controlling 100% of the house with only 20% of our own money, we are actually reaching an easy 20% return.
- Buy house for $150,000 with $30,000 out of our pocket (20%) and a $120,000 loan.
- House appreciates $6000
- $6000 is only 4% return on $150,000
- $6000 is an awesome 20% return on the $30,000 we put out of our own pocket
This is a rather simple exercise and doesn’t take all the costs involved in buying, keeping and selling real estate, but you got the idea, right?
Leverage can make a 4% return be multiplied to 20%, but what about economic downturns?
Be safe from bad leverage
As I mentioned, leverage can also work against you on the downside. If the house depreciates -4%, you get a hit of -20%!
That’s awful, but luckily that’s a lot we can do to be safe against bad events.
Just like the appreciation, you only realize the profit or loss if you do sell the investment. As long as you have cash flow keeping the property going, you’ll be able to navigate turmoil without too much stress.
Furthermore, appreciation is only the cherry on the cake for Rental Property investors. We don’t count on it alone to dictate our returns. What’s really interesting is the monthly cash flow, and that alone can yield great returns.
Even if your rental income does get hit, there are strategies to mitigate your losses. For instance, you can take the initial cash flows of a property and build a reserve to keep you safe from issues.
For me, that’s the big difference in Real Estate Leverage. The risk reward factor is much better for rental properties. Even when things do go down, I have enough safeguards in place to keep a good sleep at night!
- Leveraging Real Estate can turn 4% ~ 10% returns in 20% ~ 50% returns.
- Better risk/reward when compared to other leveraged investments.
- Leverage can work against you.
- Cash flow is king!
Not all leveraged investments are created equal. You can leverage stocks, currencies and pretty much everything, but I still think that taking mortgages is a better understood and easy option to put in place.
The risk/reward of Rental Properties is also incredible. Cash flow is king, and even on downturns, we can rely on cash flow to keep us afloat and profiting.
Leverage makes our ROI shine, and cash flow keeps the profits flowing even on downturns.