May fortune smile on you: Using real estate leverage to create wealth
Real estate leverage is a great way to create wealth. That sentence sounds good on paper, but what does it really mean? For starters, Webster’s Dictionary defines leverage as "the use of credit to enhance one's speculative capacity." In real estate that means using other people’s money to pay for your real estate investment with less cash out of your own pocket so that you maximize your return.
Here’s how it typically works:
(1) you use mostly other people’s money (the lender) to purchase a property,
(2) another party (your tenant) pays to carry most of the cost of your property, and
(3) someone else helps pay off any remaining debt (the buyer) when you sell the investment. As an added bonus, if you take a loss on the investment, you can usually write it off as a tax deduction. When you put it all together, the power of leverage makes smart real estate investing an extraordinary vehicle for building wealth.
How real estate can outperform stocks
Most people are familiar with the idea of investing in the stock market, but they don’t always understand how real estate compares. Here’s a scenario I like to use at dinner parties when chatting it up with financial planners who feel that stocks and mutual funds are the best bet. I’ve been using this particular story for 20 + years so the actual numbers are no longer realistic, but they illustrate the point.
Imagine we both invest $100,000.
If you invest every penny in stock, all $100,000 of that investment is cash or potentially on margin (yikes). On the other hand, a real estate investor buying an imaginary house puts 20% down and is into the investment $20,000 + carrying taxes and insurance payments while a tenant typically carries part or most of the remaining debt.
For the stock guy to double his money the stock has to appreciate 100%. For the real estate investor to double his money, the property only has to increase 20%.
The biggest difference is that in real estate your equity accumulates on the total value of the home, not just the 20% down payment. If you receive a 5% appreciation over the year, the equity is built on the $100,000 value of your home not just the 20% you put down.
Which one would you rather be?
Examples of actual Austin real estate investments
But it’s not all just hypothetical. In 2018 year we had several clients who, for various reasons, decided to cash in some of their real estate investments. Here are three real life examples of how you can build wealth through real estate.
We helped one couple buy a property in East Austin for $190,000 just three years ago. They sold it in the spring of 2018 for $365,000 -- netting a profit of $175,000! If you break it down, that property earned them around $58,000 a year or $4,861 a month.
This, of course, doesn’t take into account rent, vacancies, and periodic repairs, but that’s some math I can get excited about. A 92% rate of appreciation over the full three years they owned it (around 30.53% per year) outperforms any stock or bond I’ve ever owned.
Another long-time client of mine sold his house in Rosedale and moved across the country to California. He bought the house for $507,000 and sold it for $640,000 – netting a profit of $133,000. Over the five years he owned it, he made around $26,600 a year or $2,216 a month in additional income.
Last, I had client sell a small 2 bedroom condo in Allandale. When we helped her buy it less than five years ago, she paid $131,000. This spring our client sold it for $196,000. That’s a profit of $64,700. It appreciated around $12,940 a year or a little over $1,000 a month.
Sure, some properties don’t fare as well. And we have seen people lose money when they make a poor investment choice or put too much money into a property too soon. Even so, we personally like the odds of investing in real estate.
Understanding the two basic investment models
Land typically appreciates over time, while the value of structures on the land usually depreciate. This concept plays into the two different investment models: those that want their property to cash flow up front (usually structure based) and those that are focused on long term value and appreciation (usually land based). Ideally you want to find a property that works under both models, meaning it cash flows right away and is likely to appreciate over time.
Model #1: Cash flow up front
In an ideal scenario you will find a property with a low enough purchase price that you can rent it out for more than the cost of your mortgage. In that case your property not only pays for itself but it also produces income.
Rising Austin real estate costs make it harder to find properties that will cash flow right away. To resolve this many investors look for multi-family properties (think duplexes and apartments) where the rent is lower for an individual tenant, but because there are multiple tenants the total rent collected still exceeds the cost of carrying the property. Another option is to buy properties further away where prices are lower, creating a greater spread between your mortgage payment and what you can charge in rent.
Model #2: Long term value & appreciation
Another option is to invest in a property that you expect will have long term value. Here, location of the property is key. Investors may lose money the first few years because rents aren’t equal to your mortgage, but strong appreciation helps close the gap over a period of time.
There is no right or wrong model. It depends on your risk tolerance, need for immediate income, and long term investment goals. Talk through the options with your Realtor to decide which strategy is best for you.
Tips for building wealth through real estate investing
This all sounds great in theory, but how do you actually build wealth through real estate investing? Here are some simple suggestions for building an equity-based real estate portfolio:
1. Buy at the right time, not the peak of the market. Real estate is cyclical and seasonal. Time your purchase so that you are buying at the bottom of the seasonal cycle (usually the Fall) when prices are typically 6 – 8% less. There may be less inventory to choose from, but your money will go further.
2. Be willing to hold the property for a period of time. Real estate usually appreciates over time. The longer you hold onto a property, the greater appreciation (and profit) you will see.
3. Know where large developments are being built. Try to invest in neighborhoods where you can expect future growth and development. You can see our neighborhood appreciation picks here.
4. Pay attention to properties that other people will overlook. Does the house look awful online? Is it hard to tell anything from the photos? Those are the houses that grab our attention. Other people are likely to overlook these homes, meaning you may end up with a better deal than if you are competing for a cute, remodeled cottage in Central Austin.
5. Work with an experienced Realtor. When it comes to finding an investment property, you want an experienced Realtor who knows the ins and outs of the market, can reasonably predict where appreciation is likely to occur, and will steer you clear of making a bad choice.
Alternate investment vehicles
Not everyone has the cash to buy an investment property outright. Fortunately, there are other ways of doing it. All of these options have pros and cons that are beyond the scope of this article; please reach out if you want more detail about any of these strategies.
1. The slow flip. Your own home can be a great investment property. Buy a home, live there for several years, wait for the market to ripen, sell it, and repeat.
2. Invest with a group. Sometimes you can get further if you partner with other folks on a real estate investment. Friends, family members, and business colleagues sometimes create business ventures, like a limited liability corporation, that allow them to share the risk of a real estate investment.
3. Real estate investment trust (REIT). A real estate investment trust, aka REIT, is another way to get involved in real estate investing. Essentially you pool your money with a group of individuals and put it in a trust; the REIT trustee then reinvests the money in real estate.
We love helping our clients build wealth through real estate, and we’d be happy to do the same for you. Just call, text, or email us to schedule a free, no obligation consult.
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