Real estate as an asset class does not provide exceptional, life-changing returns on its own. For many, the 3-8% return is simply not enough to justify the investment. Given real estate investing considerations such as low liquidity, concentration risk, and ongoing management demands, many investors may prefer to simply buy publicly traded securities like stocks and bonds when expected returns are the same.
So why is real estate such a popular investment class and how do real estate investors amass immense wealth if returns aren’t extravagant? Leverage. Real estate investors like leverage (i.e., debt) because it allows for greater return on equity.
What is a return on equity?
Return on equity is the net income divided by the amount of equity contributed, where equity generally refers to the investor’s cash put into the investment.
Return on Equity=Net Income ÷ Equity
Consider the following hypothetical investment: a single-family home is purchased as an investment property for $100,000 and provides a net income of $7,000 after expenses and outgoings. Here, the return on equity is 7%. That is, for every $100 of equity contributed, the investor can expect $7 in net income. For this reason, most real estate investors focus on maximizing return on equity.
Where real estate gains its popularity and reputation as a wealth-building machine is an ability for investors to add leverage. This means adding debt to the capital structure. Rather than paying $100,000 in cash for the property, suppose the investor borrows $80,000, requiring a 20% down payment of $20,000. Here, the investor’s equity is only the $20,000. Now, let’s assume that the net income after factoring in the new debt repayment is $3,000. Although the debt has reduced the net income, it has improved the return on equity by reducing the equity contribution to more than offset the lower net income.
Here, the leveraged investor generates a return on equity of 15% ($3,000 Net Income /$20,000 Equity = 15% Return on Equity). Assuming ample investment opportunities exist like the hypothetical one above, the investor could then buy four more identical properties at $20,000 down with his or her remaining $80,000. Thus, the total net income for the leveraged investor would be $15,000 ($3,000 per property x 5 properties) compared to the unleveraged investor’s return of $7,000. However, leverage is not a free lunch.
Leverage increases financial risk.
Although leverage increases returns when things go right, it also amplifies losses when things go wrong. The additional debt repayments increase the required outgoings for each property which in turn reduces the buffer between cash inflows and outflows. Thus, leverage heightens the risk of a financial disaster by demanding greater inflexible cash outflows.
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