Leverage is the use of various financial instruments or borrowed capital to increase the potential return of an investment – and it is an extremely common term on both Wall Street and in the Main Street real estate market. (Learn more about the various uses of leverage in Leveraged Investment Showdown.)
Consider the common real estate purchase requirement of a 20% down payment – or $100,000 on a $500,000 asset. The buyer is essentially using a relatively small percentage of his or her own money to make the purchase, and the majority of the money is being provided by the lender. Real estate investors often refer to the remainder of the purchase price as "other people's money," since persons other than the borrower provided the money needed to make the purchase.
Assuming the property appreciates at 5% per year, the borrower's net worth from this purchase would grow to $525,000 in just 12 months. Comparing this gain to the gain from an unleveraged purchase highlights that value of leverage. For example, the same borrower could have used the $100,000 to make an outright, paid-in-full purchase of a $100,000 property. Assuming the same 5% rate of appreciation, the buyer's net worth from the purchase would have increased $5,000 over the course of 12 months versus $25,000 for the more expensive property. The $20,000 difference demonstrates the potential net worth increase provided through the employment of leverage. Now, picture that 5% gain every year for 20 years. Over time, the use of leverage can have a significant, positive impact on your net worth.
Ways to Access Leverage
The easiest way to access leverage is to use your own money. In the case of a mortgage, a standard 20% down payment gets you 100% of the house in which you want to live. Some mortgage programs let you put even less money down.
If you are purchasing the property as an investment, you may be in a position where your partners furnish some (or even all) of the money. Similarly, some sellers are willing to finance some of the purchase price of the property they wish to sell. Under such an arrangement, you can purchase a property with little money down and, in some cases, no money down at all.
Infomercials, Scams and Reality
Images of no-money-down purchases bring to mind those late-night infomercials where smooth-talking pitchmen suggest that you can earn millions of dollars buying properties with no money down. While this is possible, there are some questions you should ask yourself before jumping in:
- How many people do you personally know who became millionaires working 20 hours a week because other people sold them valuable real estate with no money down?
- If you had a genius plan whereby people gave you millions and millions of dollars worth or real estate with no money down, why would you need to make late-night infomercials selling real estate buying lessons?
The Dangers of Leverage
Just as leverage can work on your behalf, it can also work against you. Revisiting our earlier example, if you use a $100,000 down payment to purchase a $500,000 home, and real estate prices in your area decline for several years in a row, the leverage works in reverse. After year one, your $500,000 property could be worth $475,000 if it depreciates by 5%. A year after that, it could be worth $451,250 - a loss in equity of $48,750.
Under that same 5% price-decline scenario, if that $100,000 had been used for an all-cash purchase of a $100,000 home, the buyer would have lost just $5,000 the first year home prices fell.
In real estate markets where prices fall significantly, homeowners can end up owing more money on the house than the house is actually worth. For investors, declining prices can reduce or even eliminate profits. If rents fall too, the result can be a property that cannot be rented at a price that will cover the cost of the mortgage and other expenses. (If you are contemplating becoming a landlord, read Tips For The Prospective Landlord and Becoming A Landlord: More Trouble Than It's Worth? for a look at the pros and cons.)
The problems get even bigger when multiple units are involved, as real estate investors often put down as little money as possible. The goal is to leverage your money by taking control of 100% of the assets while only putting down 20% of the value. Consider the $500,000 we reviewed in our previous example. Since the home is purchased with $100,000 as a down payment, if the value of the home declines by 30%, the home is worth just $350,000 but the investor still must pay interest and principal on the full value of the $400,000 loan. Should the amount the investor gets in rent decline too, the result could be default on the property. If the investor was using the cash flow from that property to pay the mortgage on other properties, the loss of income could produce a domino effect that can end with an entire portfolio in foreclosure over one bad loan on one property.
Leverage You Can Live With … and In!
Although they may not think about it as leverage, most people use a mortgage when they buy a home. They pay off the loan over a period of years or decades, all the while getting to enjoy the use of the property. The moral of the story is that leverage is a common tool that works well, when used prudently.