Next to owning your own business, investing in real estate gives you the highest potential return on investment (ROI). The reason you can get such high returns on real estate is because of the power of leverage.
Let me explain.
When you’re a real-estate investor, you’re essentially in the business of finding other investors to back your projects. Those investors are lending institutions or private lenders. They receive interest payments from you and, initially, loan fees. You get to keep the profits.
This is what is called “positive leverage.” Essentially, you are borrowing most of the money you need. It means you can ratchet up your profits by using other people’s money to control an appreciating asset – and it’s one of the great advantages that real estate has over the stock market.
In a typical leveraged (i.e., mortgaged) real estate deal, you can invest $10,000 to $20,000 (or less) to buy a $100,000 property. If that property appreciates 4 percent (or $4,000), then the ROI you achieve is not 4 percent but 40 percent or 20 percent, depending on whether you invested $10,000 or $20,000.
I’m simplifying things for the moment, but stick with me. This is a pretty interesting subject. If the property “cash flows” (meaning, if the rent you get for it covers your loan costs plus taxes, insurance, and an allowance for vacancies and maintenance), you benefit from all the appreciation multiplied by the amount of leverage you took.
A 90 percent mortgage (one in which you put up only 10 percent of the property cost) gives you a 10-to-1 leverage advantage. A 95 percent mortgage gives you an 18-to-1 leverage advantage.
In other words, you get all the net cash flow. And you get all the equity built up from paying down the loan (amortization).
For example, let’s say you put $10,000 down on a $200,000 property. If you waited three years to sell it and, at that time, its value had gone up to $300,000, you would have turned your $10,000 into $110,000 – not including the net rents you’ve accumulated and the amortization you’ve picked up. Subtract your buying and selling costs, and you should still make 10 times your money (or more) in just a few years. That’s the power of financial leverage.
Having a mortgage would increase your costs – roughly by the amount of interest you would pay (the cost of the money you are financing) – and so you might end up paying some additional fees. But overall, your returns on the property would greatly outweigh the cost of the investment.
(Ed. Note: The above article is an excerpt from the book EVERY graduating student should haven Michael Masterson’s just released Automatic Wealth for Grads… AND ANYONE JUST STARTING OUT.)[Ed. Note: Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]