Friday, February 17, 2017

A 'Real' Example of Real Estate Leverage

I haven't written much lately; partly because life is busy, partly because I am still somewhat doing a 'side gig' and pursuing other interests, partly because the "payoff" from a PassiveIncomeDude article is very low currently, and partly just because I haven't had much to say.  I am drastically paying down debt and contributing regularly to ROTH IRA investing, which has resulted in nothing 'exciting' going on with my investments, in terms of buying stocks, buying properties, or selling etc.

That said, I am currently in the process of marketing my North Carolina Property (here) for rent this summer, and I witnessed a great example of leverage recently that I thought would be useful to share.

As some of you may know, I am a HUGE fan of leverage, especially and specifically real estate leverage, where your leverage is backed by a 'real' asset (the lumber, steel, concrete, glass, petroleum products, brick, etc) that all go into making a house AND it is an asset that you actually control.  This is in direct and stark contrast to "stock market leverage," where you only have very, very minuscule and indirect control of whatever the company's market valuation happened to be  on the day you decided to buy.  Huge differences there worth a re-read.

All of that said, I have written about leverage (here) before on PassiveIncomeDude, where I used the example of my Colorado Property to show how I achieved a 100% return in just one year.  It is an extremely powerful example of leverage that I think is worth the few minutes of reading.

Now back to my current example from the previous owner of my North Carolina property:

Here is a picture of my NC home to offer some context on the example I am about to discuss. I encourage you to look at my North Carolina Rental page to learn more about this investment:

As I was looking over this home's history before I became the owner, I noticed the following stats:
  • In November 2008, the home was built and sold for $259,000
  • In May 2015, I purchased the home for ~$299,000.
Therefore running some simple math, the original owner experienced 15.4% appreciation from his original purchase price to his final sale price.  

But you may notice, this 15.4% was over about 6.5 years. TERRIBLE you think.  Only 15.4% in 6.5 years!  That is only about 2.4% growth per year!  Real estate is a terrible investment.

But wait.  What if the owner followed a typical financing agreement and put 20% down, and therefore leveraged his money 5 to 1.  Let's explore that further.  To begin, a little set up is necessary:
  • It costs him roughly $51.8K as a down payment.  He therefore had a loan balance of $207,200 when he started.
  • Let's also start by assuming he didn't pay his loan balance down AT ALL during these six and a half years (which is obviously not realistic given his required monthly mortgage payment, but it simplifies our example).  If that is the case he had $91,800 in equity when he sold.  This 91.8K is easy math: his down payment of 51.8+40 of home price appreciation when he finally sold.
So what was his return on his initial investment?

Due to his leverage of 5 to 1, his total return was not 15.4%, but was actually 77.2%! This equates to a much more respectable and 'typically-S&P500-beating' return of 11.9% per year!  

Wow.  I hope you did not miss how drastically his return changed. Due to leverage.  A simpler way of arriving at this 'levered return' would be to just take the original 15.4% and multiply it by his leverage factor of 5, which also gives you the 77% total return. But I wanted you to see the 'real estate' numbers in action proving it as well.  With very slow 2.4% growth, he achieved a 11.9% per year return.

Now, obviously his return would be different if we removed our simplifying assumption of no loan paydown each month where he essentially 'got back' all of the equity he accumulated via his mortage payment each month. But of course there is some debate about this, since he had to contribute 'more' capital each month while he lived there, which you obviously don't have to do with a stock purchase, but I am not going to get into that, and my simple response would be, "hey you have to live somewhere!" And I can tell you that I played around with the math a bit on this and the return is still very respectable. Even with a relatively low 2.4% per year appreciation input that we used.

Well, I hope that gets you excited.  It gets me excited, and you can do this too!  Imagine if the growth was higher, and the leverage was higher. Both real possibilities that I've experienced, even in my Colorado Rental for example.  As such, I made a quick table showing some different scenarios of home appreciation and leverage:

Stop and consider that.  Following the item in the last row, if your investment only appreciates 6%, but you put only 5% down (and are therefore 20 times levered), your return is 120%!  In one year.  Consider if this happens for several years!

What do you think? I'd love to hear your thoughts on leverage, and home appreciation, any real estate investment examples you may have, etc.  Thank for reading,

Passive Income Dude

1 comment:

  1. Very interesting article -- thanks for sharing. I'm going to have to do some calculations on our properties, now! :-)