When I have a question about investing, my go-to person is always my husband David- his years of experience and success are the first indicator I’m talking to the right guy. This is part of a discussion we had recently about rental residential real estate vs. publicly traded securities:

David: “There are several reasons I prefer rental residential real estate, but the primary reason is leverage.  Another way of saying this is that as a real estate investor, I get to use my lender’s money (the loan) as well as my down payment to make money on the appreciation of the property I buy.

For example, I can buy a $250,000 property with $200,000 of Bank financing and $50,000 of my funds.  This is a standard deal for an investor.  If the property appreciates just 2% ($5,000), I earned $4,000 on the Bank’s money and $1,000 on my personal funds.  However, I get the benefit of the entire $5,000 when I sell the property.  Leverage is quite powerful boosting my return from 2% to 10%.

Now, I can also buy $250,000 worth of stocks, but I will probably need to use $125,000 of my own funds.  A 50% margin is allowed.  Furthermore, if the market declines and the stock value decreases, I have the added burden of a margin (cash) call.  This does not happen with my real estate purchase.  If the property declines in value, my leverage decreases, and the bank becomes more at risk, but I am not required to offset this decrease in value with more of my own funds.

If I have excellent credit and lots of income, I can leverage even more.  Take my $250,000 property (A).  I again put $50,000 of my funds into the purchase, but I borrow $45,000 of these funds from a different property (B) with substantial equity.  In other words, I use the funds from property B to help finance property A.  Now I have $5,000 of my own cash in property A – and I am 98% leveraged.  Here again, if property A increases 2% in value, I have a gain of $5,000 when I sell the property which is a 100% gain on my own cash.

Also keep in mind that leverage can hurt you badly if you are not careful using this approach.  In general, leverage increases the monthly cost of the property and a downward valuation removes your equity very fast.  Many of today’s current mortgage problems reflect an over-leveraged buyer situation.”

If you have any questions about using leverage in a transaction, or would like David to answer any other questions about real estate investment- Let me know! Post your comment here or send an email to jane@janefairweather.com .

Have a wonderful day!

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