Leverage and returns with Real Estate
Real estate is most often purchased using leverage. Leverage refers to the purchase of an investment with borrowed money (the mortgage). The effect of leverage is that both gains and losses on the investment are magnified dramatically.
Consider the following two examples:
The Smith family has $25,000 to invest. They choose to invest in the stock market by purchasing mutual funds. If the stock market rises by 10%, the value of the Smith family’s investment will increase by $2,500. If the stock market falls by 10%, the Smith family will lose $2500 on their investment, leaving them with an investment worth $22,500.
The Jones family also has $25,000 to invest. They choose to use the money as a down payment to purchase a $250,000 investment property. In two years, the value of the property has increased by 10% and the Joneses’ decide to sell their property for $275,000. The gain represents an increase of 100% on their original cash investment.
However, should home prices drop by 10%, the value of the $250,000 house will fall to $225,000. In this event, the Joneses have lost 100% of their original $25000 cash investment.
