The most fundamental attributes of Real Estate, beyond the fact that it’s, well, real, is that is can be borrowed against. The action of borrowing money, much like a lever for moving physical things, has the effect of amplifying things. A small push on the right lever can move a large object.
This amplification has several effects on real estate and other financial instruments. Leverage amplifies returns (profits), as well as risks and loss. Much like a sensitive electric guitar plugged into a big amp, small changes have a much larger impact.
So here’s the basics of leverage for real estate investing.
First, leverage can be calculated by dividing the purchase price (i.e. asset value) by the cash required to purchase it. For most purchases, for most people, this is 1.
So when you buy a $100,000 house for all cash, your leverage ratio is 1.00.
However, with Real Estate it’s normal to borrow part of the purchase price with a Mortgage. This amplifies the numbers, leading to a leverage ratio of 10.
What this does is amplify the return (or loss) on investment. Return on Investment (R.O.I.) is calculated with the following formula:
So assuming we buy a $100,000 home and it appreciates (or otherwise generates a return of $10,000), we get a return of 10%
If, however, we’ve only put down $10,000, as above, we get the 10x leverage as above, creating a return on investment of 100%.
The principle of leverage is one thing that separates real estate from other investments, and has made home ownership possible for millions of people over the past several hundred years.