Leverage is my favorite word, when it comes to discussing real estate investment. Leverage is about the use of other people's money. The concept is simple and powerful.
The use of other people's money, is the concept of using money generated by someone or something else. While it is true that you can leverage stocks (to some extent), there is no other application of leverage which is more powerful than the leverage found in the real estate industry.
In real estate, leverage is based on the asset itself and how much you can get a bank to loan money on this asset - whether it be 80%, 90% or 100 percent, of the total asset value. Why do banks do this? Because they can repossess the physical asset itself should you default. When buying stocks, often you can only borrow up to 50 percent of the stocks value. Not to mention, you must purchase stocks through brokerages (not banks), at high interest rates. In other words, when you buy stocks, you are taking the risk. But when you buy real estate (with a loan), the bank is taking the risk.
What's more, buying stocks is considered far riskier (than real estate), because of the volatility of the stock market. If your portfolio takes a huge dip, you still have to pay the margin, but have no asset to fall back on. Buying on margin is an investment where you can actually stand to lose more money than you invested. Where real estate on the other hand, is a physical asset that you can fall back upon, and less volatility, which is why a bank will be your partner.
So how is it that an investment in real estate with a 6% percent rate of appreciation, can be a better investment than a stock yielding a 10 percent rate of appreciation? One word: leverage.
When you leverage an investment, you reap the benefits of the appreciation on the total asset value, while only having a small percentage of your own money in the deal.
In any investment, the goal is to have the highest cash-on-cash return, or return on investment (ROI) possible. ROI is the percentage return on your investment as compared to your invested dollars. In order to determine ROI, you divide the amount earned by the original investment.
ROI = Return on Investment (divided by) Original investment
Here's an example. Let's consider that $200,000.00 property we discussed earlier. Given the fact that after thirty years the property is now worth $1,083,6768 (based on a 6% annual appreciation rate), we take the value ($1,083,678.00), divide by our original investment ($40,000.00) to find our percentage ROI, divided by the number of years we held the investment.
INVEST IN REAL ESTATE
$1,083,678. (divided by) $40,000.00 = 2.709% (divided by) 30 years = 90.3% per year
In this example, our ROI would be 90 percent. Is that not unbelievable? And that doesn't even include the cash flow generated from the property or your tax breaks! Now let's compare that return on that $40,000. invested in real estate (w/ a 6 percent annual appreciation), compared to the $40,000. invested in stocks (w/ a 10 percent annual appreciation), for the same amount of time.
If you held on to your stock for the same thirty years, and it appreciated at 10 percent per year (instead of 6 percent) for thirty years, your $40,000. of stocks would be worth $634,524. That would mean your ROI would be:
INVEST IN STOCKS OR BONDS
$634,524 (divided by) $40,000. = 1,586 percent (divided by) 30 years = 52.8% percent per year
Don't get me wrong, 1,658 percent return on your money is an awesome return on your investment - but it isn't the best return on your money - when you compare it to the return yielded from purchasing real estate.
Do you not find it amazing, that a return on a stock that produces 10 percent per year is nearly 50 percent less than a return on real estate that produces 6 percent per year? Even then, we are not taking into consideration the cash flow or the tax advantages on real estate investing - which you do not get from purchasing stocks or bonds. This is the magic of leverage, and the power of real estate. If you do your homework, more times that not, you will find markets and purchase property, where the appreciation level is well above industry averages for a given area.