How do you leverage wealth

The word leverage has different definitions and has slight nuances depending on the context it’s being used in. I’d like to talk about it in this particular post in terms of real estate investing.

In this case, leverage means to use borrowed capital to increase the return of your investment. To many of you that might sound scary, but if you’re a homeowner, you’re likely using this very thing.

Leverage – Use borrowed capital to increase the return of your investment

Most people I know don’t buy a home outright in all cash. (Wouldn’t that be nice though!) Instead, they usually put down a down payment (20%) and borrow the rest (80%) from a bank to acquire an asset (your home). You plan on paying the mortgage over time and I’m sure all of you hope that it will increase in value over the years. The amount of gain is a direct result of appreciation & leverage.

So in other words, leverage is a powerful tool that allows a smaller investment to control an asset that has a higher value. Therefore, small appreciations in the value of the investment result in much larger overall gains.

Leverage to Wealth

So, how can it make you wealthy? Well, it can magnify your returns tremendously.

Here’s a basic example to illustrate this concept and here are the set of assumptions in this model:

  • I’m using the widely accepted 10% average annual stock market gains, compounded annually
  • I’m using 5% appreciation in national average home value (this value differs from 4-6% depending on your source)
  • Not factoring in inflation or taxes
  • In purchasing the investment property, it is one where the tenant covers the expenses involved (mortgage, taxes, insurance, maintenance, etc.). Not hard to do, as referenced here.
  • Even though tenants are paying off the debt, I’m keeping the original debt amount the same to make calculations easier. In reality, the debt would be slowly paid off and diminish, adding to the investment property’s equity.

If you had $100,000 to invest completely in the stock market, this dollar amount purchases a set amount of shares equaling this value. Forgetting the transaction fee, at that current moment, your $100,000 buys you shares of stocks worth exactly $100,000.

Now let’s say instead you purchase an investment property that’s also worth $100,000. However, in this case you’re able to take out a loan on the property and put a down payment of 25% ($25,000) with the bank lending you $75,000 to purchase it. You now control this $100,000 asset using $25,000. This an example of simple leverage.

Continuing on, let’s say the value of both assets, stocks and investment property, both grow at their expected growth / appreciation rate. What are you left with after a year? Let’s take a look:

StocksReal Estate
Purchase Price100,000100,000
Investment Amount100,00025,000
% Annual Gain10%5%
Value of Investment after 1 year110,000105,000
Gain in Value10,0005,000
% Return on Investment*10%20%

*Your return on investment is calculated by taking the gain in value divided by your initial investment.

You can see that even though your % annual gain in real estate is half that of stocks, your overall % return on investment can be double because of the use of leverage.
Now let’s extrapolate that over 5 years with gains compounded annually. You can start to see how leverage makes a tremendous impact.

StocksReal Estate
Purchase Price100,000100,000
Investment Amount100,00025,000
% Annual Gain10%5%
5 Year Value of Investment161,051127,628
Gain in Value (subtract debt)61,05127,628
Overall Return on Investment61%111%

To make it even more interesting, at the initial time of purchase, instead of just using $25,000, you used the same $100,000 you would’ve used purchasing stocks, used it as a down payment (25%) and using leverage purchased a property valued at $400,000. Well, here’s what that looks like after one year:

StocksReal Estate
Purchase Price100,000400,000
Investment Amount100,000100,000
% Annual Gain10%5%
Value of Investment after 1 year110,000420,000
Gain in Value10,00020,000
Overall Return on Investment10%20%

Here is what it could look like after 5 years.

StocksReal Estate
Purchase Price100,000400,000
Investment Amount100,000100,000
% Annual Gain10%5%
5 Year Value of Investment161,051510,513
Gain in Value (subtract debt)61,051110,513
Overall Return on Investment61%111%

Hopefully those gains looks impressive to you even with half the annual % gain of stocks. It definitely does to me.

Here’s a personal example of leverage at work:

I purchased my own home 5 years ago. The value of my home has doubled because of the “hot” market I live in. I put a 20% down payment on the home. Because of leverage, my return didn’t just double (like the home did) but in fact resulted in a 500% gain in 5 years and a 43% annualized return. The first $500,000 of gain would be tax-free if we sold, which in my tax bracket is huge! However, to realize these gains, I’d have to sell and move, but I won’t yet based on what I wrote here.

Caution

Just a word of caution though, leverage can be a two-headed beast where you can multiply your gains but can also multiply your losses in case you have to sell. Personally, I like to use leverage for my real estate investments. I don’t purchase them all in cash. However, I try not to over-leverage them meaning that if I lost some tenants, I could cover the debt service and not risk losing everything. That’s how so many people lost it all during the economic downturn of 2008. They owned a lot of investments in addition to their personal homes, couldn’t cover the debt service or mortgage, and ultimately ended up losing their entire investments.

Summary

Debt can be scary but it can also be a powerful tool when used in the right manner to accumulate wealth. I suggesta balance – don’t be so scared of leverage that you don’t use it to your advantage, however, don’t over-leverage to the point that you couldn’t survive a dip in the economy.

Passive Income M.D.