Leverage in Real Estate

Taking a step back - so why is real estate a good investment? Because you can make a lot of money with not so much money.

Let's take the case of the guy who's renting for $1,000/month. If he purchased a $200,000 house, with 10% down, his payments would be about $1,400/month (assuming 6% interest rate). After taxes, the actual out of pocket difference is minimal between the mortgage payment and rent. It's worth pushing yourself a little bit here. The payments may start off a bit difficult for you, but they get easier as you adjust and make more money. Work for that raise or promotion!

So, this guy needs $20,000 to start. But there are loans where you can buy a house for as little as 5% down. The monthly payments would be higher, but now you only need $10,000 to start.

Now, in a hot real estate market, that $200,000 property could go up $50,000 a year. Maybe even more. Year after year. And even though you've only put 5% or 10% down on the property, you get 100% of the appreciation. That $10k could turn into $100k after a few years. That's a lot of leverage. And the risk is low. Real estate inevitably goes up over time. In the worst case scenario of real estate taking a nosedive, well you still need a place to live anyway, so ride it out. Even in the area I live, which was thought to be topped out, I read in the paper that real estate appreciated 11%.

So, compare this to the stock market. Let's say you invest $20,000 into the market, and your securities go up 10% for the year. That's a great return and you've just made $2,000. Now compare that to the scenario above. You use the same $20,000 as a down payment, and your house appreciates 10%. You've made $20,000, or 100% of your investment! Not to mention, if the house is your primary residence, you won't have to pay taxes on your gain for up to $250,000 worth of profits, unlike stocks where you will have to pay taxes on any gains you make.

But certainly, real estate is an investment, there is risk. Do your homework and scope out different areas, their rate of appreciation, jobs moving in, the city improving or expanding. Look for a place that you can fix up a bit and immediately increase the value of. As you've heard, location is important. And a rundown place in a great location is ideal - new paint, carpet, tile, etc. is cheap, but somehow increases the value of your place by tens of thousands immediately.

Half of the "so-called" experts say the market is heading down. The other half say the market is strong and will stay that way for a long time. The real estate market is comprised of local markets. Any statement made about real estate in general doesn't make sense to me. There are always spots that are appreciating like crazy, while other spots are stagnating. Granted, rising interest rates can slow down housing in general, but guess what. If rising interest rates make loans too expensive, then people end up renting. Now the rental market strengthens, and if you own rental properties, well your appreciation may be slowing but you can raise rents.

My next post will be about the mistakes I made on that first purchase. Even though I made money on it and it would help me with my next move, I should have done things differently. Lessons learned coming next.