The concept of leverage tends to scare a lot of people, at least as far as certain types of investments go, especially with leveraging stock market investments. They may not realize that real estate purchases also involve leverage, and quite a bit more leverage.
Whenever we borrow money to buy something, the purchase is leveraged. The borrowing provides the leverage. If we buy stocks on margin and put up half the money and borrow the other half from our broker, we have leveraged our position, where we now control twice as much stock as we would had we bought it with cash.
Futures, contracts for difference, or other securities that are highly leveraged, are often seen as being very risky. They certainly might be, depending on the skill of the trader, but those who take these risks into account and manage them, and also have a positive expectation with their trading, can do very well with this much leverage.
The more leverage we use, the greater the risk, simply because the larger positions that we control from the leverage will have a bigger effect upon our end of the investment. For example, If you buy a certain amount of stock with cash and it drops 50%, you lose half your money, but if you only put up half the money for the stock, you lose all of it.
Few people put up all of the money for a real estate purchase, and just about everyone, including billionaires, borrow money to buy it. The percentage of the money put up by buyers tends to be fairly low, in the range of 5-20%, which means that these purchases are indeed highly leveraged.
Why Leveraging Matters in Real Estate Investments
What distinguishes securities such as stocks bought on margin versus real estate bought with a small down payment, which we could consider to be margin as well, is that real estate purchases aren’t subject to margin calls.
If your stock that you purchased on margin drops in value greatly, your broker may make a margin call, where you either have to put up more money or your trade will be closed. In cases of margin calls, the real thing that has gone wrong is that the trader or investor has not closed their positions earlier, preferably much earlier, and being even close to getting a margin call is a bad idea in itself. Hanging on to positions that have moved against you greatly is like dancing with the devil for the most part, as it not only is indicative of very poor risk management, the risks of being harmed further are also great.
On the other hand, one may either plan or be forced to sell their real estate investments at a time where they have lost a lot of value, and people do lose significant amounts of money at times when this happens.
If you bought a home for $500,000 and sold it for $400,000, you have lost $100,000 on the investment, whether this came out of your own pocket or owe the money. Even though money owed is often not paid back, where the property becomes foreclosed and the borrower declares bankruptcy or otherwise does not make good on the debt, this still does have significant financial consequences to the borrower.
While the potential of selling properties at a loss when the real estate market moves against you and you choose to sell or have to sell is a risk that a lot of people are aware of, a lot of people really don’t think much about this risk or pay much attention to the real estate market generally.
People will pay inflated sums of money for real estate during a big boom even though many experts may be predicting that these prices aren’t sustainable and even may suggest a correction or a crash is on the horizon. This may not in itself be a reason not to buy, but the real estate market should at least be something people take into account enough when it comes to deciding these things, which is often not the case.
How Leverage Affects These Risks
If someone only has $10,000 to invest in something, and the market pulls back 25%, if the investment were in cash, one would be subject to only losing 25% of their investment, in this case $2500.
If we use that as a down payment on a $500,000 house though, and the market pulls back the same amount, we have not only lost our initial investment, we have lost 10 times more than we put up, losing our $10,000 plus another $90,000.
We might think that as long as we don’t sell during this time and just hang on to the property until it goes back up, none of this will matter. The good thing is that the bank is too invested in the mortgage to ever want to foreclose on it unless really necessary, and as long as borrowers continue to make payments on time, lenders won’t be concerned about whether the value of the real estate has gone down or even whether the credit worthiness of the borrower is in shambles.
Borrowers can default on anything and even declare bankruptcy or have judgements against them and none of this is of any consequence provided that clients do not seek to borrow more and just want to pay off what they owe on their properties.
However, often times borrowers want or need to borrow more, or at least look to consolidate other debts, and this is where the risk involved in the leverage they have obtained will certainly matter.
Initially, our equity will consist of the difference between what the home is worth at the time of purchase and how much we owe on the mortgage, which almost always works out to the amount of our down payment. In our example, we would have $10,000 worth of equity, by putting that much down, although this equity cannot be used if it is the minimum amount required by the lender.
Making larger down payments will increase this initial equity, and if our down payment is large enough, we may be able to use some of this equity right away, before the property value goes up to increase it. For most buyers though, this isn’t the case, and they will rely on both increasing property values and paying down the principal of their mortgage to build equity.
Just like leveraged purchases of stocks, the leverage involved in real estate will benefit the property owner as the value of it increases. If our home increases in value from $500,000 to $550,000, increasing by 10%, the buyer will realize an increase in wealth of $50,000, or 5 times the initial investment.
This increase in wealth can be used for practical purposes, either by realizing the gain by selling the property, or by using the equity to borrow against it. There is very often a need to borrow against it as many people accumulate other debts at a higher to much higher rate than they can borrow against their property and get, so this does matter quite a bit in many situations.
Both these purposes, realized profits from selling real estate and gains from the financing that increased equity can provide, offers property owners some very real benefits. Some of these benefits may be financial, monetary profit from the sale of property or interest savings from refinancing, and some may be non monetary, such as one being able to buy more things and enjoy life more.
Leverage is a double edged sword though as they say, and this can end up working against the buyer should the value of the property drop, where one may lose or be deprived of the ability to borrow against one’s home equity.
Managing the Risks of Real Estate Leverage
Some may say that one should not put themselves in positions where this borrowing is required, but that is easier said than done, especially with larger purchases such as buying a car. People could perhaps be more frugal and save up for these purchases, and not spend anywhere near as much on them, but the reality is that many people do borrow quite a bit.
Still though, although borrowing for things other than one’s home may be seen as required, one can and should show enough restraint with one’s borrowing such that one may at least require to borrow less.
It is especially important to look to avoid situations where we rely on borrowing against our equity to maintain our financial stability. The ability to borrow at the lower interest rates and the longer terms that secured borrowing offers should be seen as a bonus, something we may benefit from but don’t really require.
A great many people do put themselves in positions where secured borrowing is required, and when one is unable to do so, this can even lead to financial ruin in some cases. When we overextend ourselves by borrowing, this is where the mistake is made, and we can’t blame other things such as the declining real estate market for not bailing ourselves out of situations we should not have placed ourselves in at all.
The more our real estate purchases our leveraged, the greater the effect property value fluctuations will have on our overall position. This doesn’t mean that we shouldn’t be leveraging real estate purchases as much, and to the contrary actually, as this leverage is why real estate investments are so profitable.
On the other hand, we do need to be aware of the risks involved in having to borrow a very high percentage of the purchase price when we buy a home, and take the proper steps to ensure that we don’t end up in a bad position if things don’t always go our way in the manner we hoped.
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.