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In the world of stocks and bonds, using leverage is referred to investing “on margin,” or with borrowed money, but we’ll leave that lesson for another day.
The math laid out below shows how leverage can be a real boon to the investor’s return when returns are positive. When returns turn south, leverage can come back to bite you.
As is usual on a Saturday, this post originally appeared on WCI Network partner site, Passive Income MD.
How Leverage Can Multiply Your Returns & Create Massive Wealth
The word leverage has different definitions and has slight nuances depending on the context it’s being used in. I’d like to talk about it in this particular post in terms of real estate investing.
In this case, leverage means to use borrowed capital to increase the return of your investment. To many of you that might sound scary, but if you’re a homeowner, you’re likely using this very thing.
Leverage – Use borrowed capital to increase the return of your investment
Most people I know don’t buy a home outright in all cash. (Wouldn’t that be nice though!) [PoF: Have you met me?]
Instead, they usually put down a down payment (20%) and borrow the rest (80%) from a bank to acquire an asset (your home). You plan on paying the mortgage over time and I’m sure all of you hope that it will increase in value over the years. The amount of gain is a direct result of appreciation & leverage.
So in other words, leverage is a powerful tool that allows a smaller investment to control an asset that has a higher value. Therefore, small appreciations in the value of the investment result in much larger overall gains.
Leverage to Wealth
So, how can it make you wealthy? Well, it can magnify your returns tremendously.
Here’s a basic example to illustrate this concept and here are the set of assumptions in this model:
- I’m using the widely accepted 10% average annual stock market gains, compounded annually
- I’m using 5% appreciation in national average home value (this value differs from 4-6% depending on your source)
- Not factoring in inflation or taxes
- In purchasing the investment property, it is one where the tenant covers the expenses involved (mortgage, taxes, insurance, maintenance, etc.). Not hard to do, as referenced here.
- Even though tenants are paying off the debt, I’m keeping the original debt amount the same to make calculations easier. In reality, the debt would be slowly paid off and diminish, adding to the investment property’s equity.
Now let’s say instead you purchase an investment property that’s also worth $100,000. However, in this case you’re able to take out a loan on the property and put a down payment of 25% ($25,000) with the bank lending you $75,000 to purchase it. You now control this $100,000 asset using $25,000. This an example of simple leverage.
Continuing on, let’s say the value of both assets, stocks and investment property, both grow at their expected growth / appreciation rate. What are you left with after a year? Let’s take a look:
| Stocks | Real Estate | |
| Purchase Price | 100,000 | 100,000 |
| Investment Amount | 100,000 | 25,000 |
| % Annual Gain | 10% | 5% |
| Value of Investment after 1 year | 110,000 | 105,000 |
| Gain in Value | 10,000 | 5,000 |
| % Return on Investment* | 10% | 20% |
*Your return on investment is calculated by taking the gain in value divided by your initial investment.
You can see that even though your % annual gain in real estate is half that of stocks, your overall % return on investment can be double because of the use of leverage.
Now let’s extrapolate that over 5 years with gains compounded annually. You can start to see how leverage makes a tremendous impact.
| Stocks | Real Estate | |
| Purchase Price | 100,000 | 100,000 |
| Investment Amount | 100,000 | 25,000 |
| % Annual Gain | 10% | 5% |
| 5 Year Value of Investment | 161,051 | 127,628 |
| Gain in Value (subtract debt) | 61,051 | 27,628 |
| Overall Return on Investment | 61% | 111% |
To make it even more interesting, at the initial time of purchase, instead of just using $25,000, you used the same $100,000 you would’ve used purchasing stocks, used it as a down payment (25%) and using leverage purchased a property valued at $400,000. Well, here’s what that looks like after one year:
| Stocks | Real Estate | |
| Purchase Price | 100,000 | 400,000 |
| Investment Amount | 100,000 | 100,000 |
| % Annual Gain | 10% | 5% |
| Value of Investment after 1 year | 110,000 | 420,000 |
| Gain in Value | 10,000 | 20,000 |
| Overall Return on Investment | 10% | 20% |
Here is what it could look like after 5 years.
| Stocks | Real Estate | |
| Purchase Price | 100,000 | 400,000 |
| Investment Amount | 100,000 | 100,000 |
| % Annual Gain | 10% | 5% |
| 5 Year Value of Investment | 161,051 | 510,513 |
| Gain in Value (subtract debt) | 61,051 | 110,513 |
| Overall Return on Investment | 61% | 111% |
Hopefully those gains looks impressive to you even with half the annual % gain of stocks. It definitely does to me.
Here’s a personal example of leverage at work:
I purchased my own home 5 years ago. The value of my home has doubled because of the “hot” market I live in. I put a 20% down payment on the home. Because of leverage, my return didn’t just double (like the home did) but in fact resulted in a 500% gain in 5 years and a 43% annualized return.
The first $500,000 of gain would be tax-free if we sold, which in my tax bracket is huge! However, to realize these gains, I’d have to sell and move, but I won’t yet based on what I wrote here.
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Caution
Just a word of caution though, leverage can be a two-headed beast where you can multiply your gains but can also multiply your losses in case you have to sell.
Personally, I like to use leverage for my real estate investments. I don’t purchase them all in cash. However, I try not to over-leverage them meaning that if I lost some tenants, I could cover the debt service and not risk losing everything.
That’s how so many people lost it all during the economic downturn of 2008. They owned a lot of investments in addition to their personal homes, couldn’t cover the debt service or mortgage, and ultimately ended up losing their entire investments.
Summary
Debt can be scary but it can also be a powerful tool when used in the right manner to accumulate wealth. I suggest a balance – don’t be so scared of leverage that you don’t use it to your advantage, however, don’t over-leverage to the point that you couldn’t survive a dip in the economy.
Do you use leverage on investment real estate? How about your primary home? Do you use leverage with any other investments?
14 thoughts on “How Leverage Can Multiply Your Returns & Create Massive Wealth”
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Great post.
I agree leverage can be a very powerful tool to grow your wealth. This can be done with real estate, stocks, or notes. I have been able to participate in all three.
I would highly recommend real estate for high income friends and colleagues. You can participate in upside through appreciation of the asset, debt reduction, cash flow, and depreciation. If you do not want the headache then do this via crowdfunding online.
I don’t have any leverage presently but I have in the past. I owned some beachfront condos in the early 90’s and my mortgage on my home, but it’s all been sold or paid off. I also traded commodities which is a levered investment as well as stock options. I made some money on that stuff but it was a lot of work as the market can turn on a dime. You make the money by being right more often than you are wrong, and you have to engage in strict risk management. There are ways to hedge the risk.
This is sort of off topic… but FYI you can really easily model using leverage in a stock market portfolio using both cfiresim and firecalc.
The trick is to set the stocks percentage to more than 100% and the bonds percentage to a negative percentage. E.g., input stocks percentage as 200% and bonds as -100% to model 50% leverage.
The predictable outcome: When it works, oh my gosh, it works really well. But it’s also interesting to dig down in the data and look at the investment scenarios when it doesn’t work well.
Great summary. The combination of leverage, depreciation and cash flow have created millions of real estate millionaires, including myself. I feel because of those factors, it is the single best investment you can make. I am retired from medicine today because I invested in real estate. The cash flow can cover my living expenses and is mostly tax free.
Dr. Cory S. Fawcett
Prescription for Financial Success
Cory, I am strongly considering (passive) real estate multi-family apt syndication investments and/or a more diversified real estate fund.
So basic depreciation will roughly amount to 3%/yr (divide the property value minus the land value by 27.5). There is, as part of this non-land depreciation, also some cost segregation = front-loaded higher % depreciation on non-structural items – appliances, etc, for some 7 years. But what I don’t fully comprehend is how does this total depreciation usually offset the 5-8% cash flow the first several years? Doesn’t seem like it would come to, say, 6% depreciation – or does it? Or are there other factors?
IMdunDDS,
The cash flow is “Mostly” tax free. Depreciation is figured on the total value of the property – the land. Most people figure cash flow as the cash on cash return. So it is 8% of the down payment money. If you bought a $1,000,000 property with $150,000 attributed to the land, then you depreciate $850,000. So $30,909 will be the depreciation each year. The first $30,909 of profit will not be taxed. The principal portion of the mortgage payment is part of that profit. If you had put $300,000 down on the property and had a cash on cash return of 8%, your return will be $24,000. All of it will be tax free. The depreciation that did not get used this year, will carry forward for use later. Whatever the profit, the first $30k is not taxed. More if you front load some of the non-structural items. I bought most of my property with no money down so cash profit would be lower and it would take more years to catch up with the depreciation figures. My depreciation is in the neighborhood of $60k. That is a lot of tax free cash flow. I hope that answers your question.
Dr. Cory S. Fawcett
Prescription for Financial Success
Great post. I’m still ambivalent about becoming a landlord because I don’t think I have the stomach to deal with difficult or dead beat tenants.
Otherwise I would totally do it.
It seems to me that, in the “Value of Investment after 1 year” row, you should subtract the debt. In the first example, the value of the $25k investment after one year is $30k ($105k-$75k). You still have the 20% gain. But saying the “value of the investment” is $105k suggests that you would take that much home if you sold the asset.
My best investment was investing in my group multispecialty building. Turns out we were highly leveraged in the deal and it absolutely magnified the gains (in 10 yrs the original shares have shown 875% appreciation).
Of course there are horror stories mainly with margin calls when leveraged in stocks etc. But in general when a 3rd party takes most of the risk (bank) an investor can rapidly accumulate wealth by employing this strategy.
I especially like the commercial real estate sector when banks offer non recourse loans (essentially won’t come after each investor if things go south). That really is a win win being leveraged but yet at maximum can only lose original capital
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Leverage can be a great tool as long as you don’t overleverage yourself. We currently use leverage in two ways:
(1) Our home; but this is a place we are deleveraging at a rapid pace. It will be paid off in two more years.
(2) My company stock; I had the opportunity to purchase equity in the company I work for during out last liquidity event and only had to write a check for 1/3 of the value at the time of the transaction. The company has extended me a loan for the other 2/3s at a 1% interest rate.
The interest is negligible. The potential to magnify my gains in % terms is HUGE!
Cheers,
Dom
A bit over simplistic IMHO. The calculations don’t show the purchase, holding and selling costs of the property which can be roughly 5%, 5% annually and 5% respectively of the value of property. Those are very rough estimates and haven’t taken into account the interest costs on the loan (and it’s hit to your credit score).
Shares are virtually nearly zero in nearly all those aspects and furthermore, if not leveraged, would have zero interest costs.
I believe if you take those into account, you’ll find leveraging property isn’t all that great just looking at the numbers but also it’s a time sucker as you either pay someone to look after the property or you have to do it yourself.
At the moment shares and property are much closer in merit, it’s just that people don’t usually dig deeper into the hidden costs of holding an investment property.
When a home appreciates, leverage is magic indeed. The fact that through a mortgage a bank is taking most of the risk on your house by providing you most of the money, yet you get all the gains of the value of the house is just a great system. What a win-win for the buyer.