Leverage

Whenever the concept of leverage comes up, the table is clearly divided into those that understand it and those that don't. The former usually being the minority, even in a group of people who own securities and real estate.

I've found it a concept that people either grasp immediately and intuitively, or cannot/will not understand with almost any amount of explanation.

This isn't investment advice. I'm a terrible investor. In fact, I don't invest at all. I speculate, impulsively, and wildly beyond my means.

Here's the concept, as simply as I can put it. Leverage is borrowing money to buy an investment.

The concept applies to any kind of investment, but most people encounter it when speculating on single-family homes, including the home they live in, so I'm going to focus on that.

Say you want to buy a house worth $1m. The value of that house might go up or down, but you reasonably expect it to go up, gradually. Maybe 3% to 5% a year. Something sensible. More if you're lucky.

You don't have $1m. You have $200k. If that number seems crazy to you, just divide it (and the asset price in my examples) until it fits your situation. And remember, in real estate, 80% is the number for an investment property, assuming your debt-to-income ratio supports it. You can buy your primary residence for 10%, 5%, 3.5%, even 0% down.

Since it's a house and you have 20% to put down, you can borrow the other $800k. That is leverage. You're leveraging 80% of your purchase.

Maybe the interest is 5% a year. On $800k, that is $40k a year, or around $3333/mo. That's rent on a $1m house.

Now let's say, for whatever reason, you don't care about the interest service on that $800k. That's a significant cost. We'll get to that later. Let's pretend, for now, that the interest service is money you'd have to pay anyway to live somewhere else. Or you plan to rent the house out and break even on the interest.

Here's the magic: you've tied up $200k of your capital in equity, but own an asset worth $1m. If that asset appreciates 5%, you've made $50k. That equity is yours to keep. $50k on $200k is a 25% return. If the house continues to appreciate at 5% per year, in four years you will have doubled your money. And you don't have to pay any taxes on that until you sell.

That's it. That's leverage. The bank didn't speculate on real estate; you did. And if the market goes, you will handily beat it, thanks to leverage.

But but but! What if the market falls? Leverage works the other way, too. If the value of your $1m asset falls 20%, it will wipe out your entire investment. That happens! The family house on the big lake walking distance from downtown Orlando that my parents bought for $75k in 1975 was valued at around $1m by the mid-90s. In 2017, Mom put it on the market at $750k and didn't get a single offer. Comparables pointed to a value of around $650k, or less. This year, 2024, that same house would probably sell for $1.2m. In real estate, we call that "Florida."

History might suggest a return of 5% or 10% a year over time, but you may have to put your plans to sell on hold for half a decade or more to realize that. You can find yourself in big trouble if you buy at the peak and can't hold on for a decade. If you buy with cash, you might be underwater by 20% or even 50%, but if you buy on leverage you could be in for 100%, 200%, 300% if you sell, or a lifetime of bad credit if you let the bank take it.

So leverage is a magnifier on your speculation. If the market goes up, big bucks. If it goes down, prepare to hold your breath for a very long time.

Which leads us back to the 80% you didn't pay. Most of us don't have $1m lying around to buy houses for cash. But what if you did? You can pay cash and keep yourself marked safe from market corrections, but you've tied up $1m of your hard-earned capital (you earned it, right?) that you now need to invest in something else. Instead of buying $800k of bonds or index funds or bitcoin (in 2013!), you've locked in an expected fixed return of 5% (you hope) all to minimize a paper loss in the event of a downtown.

On the other hand, you're not paying 5% a year in interest, so you have an additional $40k a year to invest, which is pretty good. But that 5% is just what you could have made investing the $800k. So we're back to just parking your capital somewhere and making 5%.

Given that, even though you have $1m, let's say you still use the leverage to buy the house since you only expect the house to return 5% a year.

Will you also use leverage to invest your remaining $800k in securities?

You can easily buy real estate on 80% leverage, but most mainstream brokerage accounts are a bit more conservative. Can I buy my favorite index fund on 80% leverage? I don't know. I don't have a favorite index fund. Like I said, I don't invest. But if I did, and I wanted to use leverage, I'd be worried about a margin call. A margin call is what happens when you buy securities on leverage and their value falls beyond a certain point. The brokerage knocks on your door and asks you to cough up as much additional cash as it takes to re-balance the leverage. If you don't, they'll sell your securities out from under you, even at a huge loss. This can happen practically overnight.

Turns out, in real estate, the bank takes a long view. Real estate is famously illiquid, so as long as you keep servicing your debt, you're allowed to keep your assets. After all, you most likely signed a 30-year mortgage, so that is plenty of time for the market to turn.

Let's revisit the money you are losing to service the debt. I'm using 5% for everything in my example. Since you borrowed $800k to buy your house, that is not money you would have had anyway, so you don't care about opportunity cost. The opportunity cost is not borrowing the money.

You probably already have a mortgage or rent payment, which is money you'd have to spend anyway. To the extent your current housing cost is ~$40k/yr, you're not losing much by leveraging. Alternatively, if you rent the house to someone else out and make something like $40k/yr doing that, you're still not losing money.

Let's say you don't want to live in the house you just bought, and you also don't want tenants. Or can't get tenants. Now, yes, you are losing $40k a year (not counting the portion of that that gets paid into equity). But if the house appreciates 5%/yr, what happens? 5% of $1m is $50k. 5% of $800k is $40k. You're hemorrhaging cash, but on paper, you're making $10k/yr, which, in this highly contrived example, works out to a 5% return on your original investment. So just leaving the house vacant and shelling out the payments like a rube, you're still beating inflation.

The reality is, you can't always take the loss when you're underwater and rents are down. All the usual risks and horror stories apply. People lose their shirts in real estate speculation all the time, in good and bad markets. People get horrible tenants who don't pay for months, have to be evicted, and do tens or even hundreds of thousands of dollars of damage. It happens.

That is a big part of why I don't think real estate is a good investment for income. It's a lot of capital to tie up to make… 5%.

With leverage, and the ability to hang on when things get rough, you can turn a conservative 5% return into 25%, double your money in five years (give or take), take your earrings (I meant to write "earnings," but "earrings" so much better), and repeat.

Again, I'm not advocating anyone run out and start speculating on real estate. But leverage is important to understand whether you're buying a home for yourself or as an investment property.

I should also point out that your debt-to-income ratio limits the amount of leverage you can use. You might qualify for a $1m loan with $200k down, but not for a $2m loan with $400k down. Also, the bank usually only counts ~75% of the rent you collect on investment properties as income, so once the debt service is deducted, your rental portfolio may hurt your income, even if it helps your net worth.

Leverage can turn an average investment into big gains. Without leverage, your bets need to be very risky (or lucky) to pay the same, assuming they don't wipe you out entirely. If you expect small adjustments down and up, but mostly up, and you can hold on through a down market, use leverage.