Real Estate Investing: Return On Investment and Leverage
One of the commonly touted advantage of real estate investing is the financial leverage that can result in enormous return on investment. A typical example usually compares investing an amount in real estate versus the stock market, where the return on investment for real estate investing far exceeds that of the stock market.
Photo by Brian W. Ogilvie via Flickr
For instance:
| Description | Real Estate | Stock |
|---|---|---|
| 1. Initial value | $100,000 | $100,000 |
| 2. Amount invested | $5,000 | $100,000 |
| 3. Mortgage or margin amount | $95,000 | $0 |
| 4. Mortgage or margin interest | 6% | 0% |
| 5. Projected annual growth | 5% | 8% |
| 6. Projected value in 10 years | $155,000 | $200,000 |
| 7. Projected profit | $55,000 | $100,000 |
| 8. Projected return on invested capital | 1,100% | 100% |
Real Estate Investing Provides Greater Financial Leverage and Return On Investment (ROI)
It’s possible to start with less capital investing in real estate because you could take out a mortgage; whereas buying $100,000 worth of stocks require $100,000 (ignoring some of the leveraged investment vehicles and margin account). After 10 years, real estate investment might appreciates to $155,000 and net you a profit of $55,000 (line 6 minus line 1), whereas stock market investment might appreciates to $200,000 and net you a profit of $100,000. However, the return on investment, or ROI, for real estate investment is 1,100% compares to only 100% for stock market investment.
But the example left out a few important details
Unfortunately, this comparison is not an apple-to-apple comparison — it ignores the cost of owning these investments for 10 years. For stock investment we could say it’s negligible and is already built into the projected annual growth. However, it’s not so simple with real estate investment, because there are significant costs that must be considered:
- Closing costs as a buyer, and then later as a seller
- Mortgage principal payments
- Mortgage interest payments
- Private mortgage insurance (if any)
- Property taxes
- Home insurance
- Home improvement
- Repair and maintenance
- Other costs associated with running a rental business
Which may be offset by:
- Rental income
- Depreciation
- Tax deductions
If the property is not an investment property — i.e., primary residence — then the costs and benefits must roughly equal to the cost of renting in a similar situation. Another factor is the 1997 Taxpayer Relief Act allows individuals to exclude up to $250,000 ($500,000 for couples) of the capital gain on the sales of their primary residence.
So the next time you hear about a great opportunity in real estate investing with ROI numbers in the thousands range, be sure to take all these factors into consideration.
What others are saying about real estate investing financial leverage:
- Is Real Estate Investing Profitable? at I’ve Paid For This Twice Already…
- The Fallacy of Return on Investment at Quest For Four Pillars
- Is David Bach’s Math Misleading? at Money, Matter, and More Musings
- Stocks Vs Real Estate, Winning Investment Strategies at The Digerati Life
- Top 4 Don’ts in Using Real Estate Leverage at About.com
- Real Estate Leverage at Peter Pays Paul
This post was featured in the Carnival of Personal Finance #146: Online Broker Tips Edition hosted by Stock Trading To Go.
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Even ignoring the other real estate costs you listed above, I like stocks better. To get the same $ return with real estate in this example, you’ll need to purchase and run two rental properties. Twice the work and headache – and twice the time to manage. In addition, you’ll have to find a lender willing to finance you for 3 homes ( your primary residence and two rental properties ). Finding lenders to do that in today’s market will be *very* tough, unless you’re simply rolling in cash.
Though you mentioned it, PMI is a very big item here that should be focused on. It’s 1% of the loan value, per year – not a small amount.
I’m a stock market guy all the way. Perhaps with more $ down and the help of a management company I would consider real estate… but it almost seems like too much hassle for not enough gain.
More fortunes have been built in real-estate than in any other asset class because of that leverage that you mention. The main reason why most people invest in stocks rather than real-estate? It’s easier!
I MAKE my money in this descending order: 1. Businesses; 2. Real-estate; 3. Stocks
I KEEP my money in this order: 1. Cash (only in current market); 2. Real-Estate; 3. Stocks.
@AJC – You won’t hear me disagree with you on real estate investing as a good investment vehicle. After all, have of my net worth is represented by equity in my primary residence — however, I am one of those lucky buyers that got in about 10 years ago.
This article is mainly aimed at those who tends to oversimplify things for beginning real estate investors leaving out important catches.
The costs and other factors you mentioned in your post are exactly why my only residential real estate investment is my home. I don’t have the time or patience for that. This is why I invest in highly researched land in the path of growth in Southern California. No headaches…you just pay your taxes, which are very inexpensive. You wait for about 10 years and get your offers from developers and consolidators. Then the company I invest with negotiates with them free of charge for the highest and best price at market readiness. They’re amazing!
I enjoy this type of long term investment. It’s not for market timers and people who demand cash flow investments. But the potential for a windfall in 10 years is beautiful if, again, the land is well-researched by a reputable company with a long term track record, such as the one I invest with. Some people don’t even have to wait 10 years. I’ve heard of those only waiting 18 months.
At the end of the day when the bell rings at the NYSE, $10 is $10. My land is building equity when I sleep; with other developers money; when there are zone changes and general plans are redrawn; when there is arbitrage. Be the last one holding up a project by not selling until they say, “name your price.” All this without any work on my part. It’s beautiful!
Thanks for your post!
Thanks for the links!
I really prefer to invest in stocks, ETFs and REITs – one big factor that people never quantify is the time they spend looking after their rentals.
Mike
Yes, thanks for the links! I’m with Mike and Pinyo that there are many RE costs that don’t always show up in the balance sheet.
Excellent article! I like to use rehab loans for my house flips. I even use this type of loan for my rental properties. It’s a zero down loan and if I sell within a year I can get the same types of returns as you mention in your article.
If I decide to keep it, I usually have to pay closing costs to convert it after a year. Oh and the other thing is that I’m making interest only payments during the rehab period. If I’m done to two months, I still have 10 months interest only and renting during that time as well. Real Estate is a great way to leverage the money you have.
@Kelly – It’s great that you found something that works for you.
@Four Pillars – I agree, time is a big factor.
@Mr. Cheap – I must be doing something right…got both of you to comment on the same day
Here’s another big cost for rental properties — vacancies.
@Vernon – Thank you for sharing your technique with us. I am not that advanced yet, but it’s interesting.
You’re forgetting a very important part about leverage — risk. Leverage goes both ways.
If, after 10 years, the stock and house are both worth 95K, then you’ve lost 5% of your stock investment and 100% of your real estate investment.
Granted, 10 years is a long horizon for something to go down.
@James – Great point. I was thinking about it the other day and you’re right.
Don’t forget leverage can work against you as well. Losing on investment means you lost on your equity and debt as well and you still have to repay the debt. I wrote a post on the matter as well
I agree real estate is always safer I run a home rehab biz in NY and I am always accepting new passive partners $240,000 buys and fixes we sell for 299,000 you take 1/2 profit plus all your invetment and all in 6-9 months max do math carton_c@yahoo.com e-mail if interested
Thanks for the links & references , I am about to invest a house its good after gone through all the pro & con. Thanks.
There is no free money. If real estate was such a great investment with returns better than 1000%, then everyone would be doing it to the exclusion of all other investments. In a free market, the returns would then decrease to a satisfactory risk adjusted basis.
Don’t get me wrong, real estate is a good investment and a great diversification play. However, the typical REIT (Real Estate Investment Trust) is expected to return 7% to 9% a year and these guys are well capitalized, well connected pros. See http://www.realestatejournal.c.....amato.html.
I have had some fortunate experiences investing in commercial real estate and write about them on my blog. However, no one just gave me easy money. I took risks equal to the rewards.
I have a rental property, the tenants damaged it, it’s vacant for a long time now and looking to sell it but the buyer, who is an investor is bidding at a very low price (way below the money I owe the bank)… I may have to bring $14,000 to the table to sell the house..
can you guys please advice me on what to do ..am losing lots of money on the house right now ..
@Dorian — Yes. And they are usually more painful too.
@Terry — Excellent point!
@Ty — I am sorry about your situation, however, I cannot offer you any advice. You may want to try http://getrichslowly.org/forums/ or http://www.pfbuzz.com/forum