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Real Estate as Leverage

A key to successful real estate investing is leverage. Leverage allows an investor to use a small amount of cash to generate large returns. Here is an example of how it works: A hypothetical investor purchases real estate worth $100,000. The investor puts down $20,000 cash and borrows the difference ($80,000). If the investor later sells the property for $120,000 (a 20% gain) and pays off the $80,000 loan, he or she is left with $40,000. This represents a 100% return on the original $20,000 investment. A 20% gain on the sale of the property was leveraged into a 100% gain on the cash invested. Of course, this is an oversimplified example used to illustrate the meaning of leverage. We did not discuss income and expenses as well as other costs, such as real estate transaction fees, loan interest, commissions, or the holding period (one year, two, or more), but the concept is accurate.

Leverage works better with real estate investments than other kinds of investments because it is easier to borrow money against real estate than other assets.

Leverage works better with real estate investments than other kinds of investments because it is easier to borrow money against real estate than other assets. Leverage also works for stock investments using a margin account, but the rules are very stringent because the stock is not a tangible asset. Land (real estate) will always be there, and they are not making any more. Creditors are eager to lend money to borrowers for real estate purchases because such loans are secure.

Not everyone who invests in real estate is successful. It has been known for real estate values to fall rather than rise. Like other investments, real estate values move up and down and in market cycles. When investing in real estate, it is important to have a long-term strategy because you may have to be in it longer than anticipated in order to realize your investment goals, if at all. Leverage works both ways. If the investor above had sold the property for $90,000, they would have suffered a 50% loss on their $20,000 investment despite the fact that the decline in value was only 10%. Furthermore, the lender was paid in full for the loan—despite the real estate loss.