Why Real Estate Investing Can Be So Powerful
Updated: May 5, 2020
When millionaires were interviewed about how they acquired their wealth, over half of them disclosed that they got rich through real estate. Although many are scared of investing in real estate because of the subsequent housing crashes, many wealthy people actually took advantage of these opportunities to become rich. So, why is real estate so powerful?
The reason real estate has been so powerful and will continue to be so powerful for many investors is a word called leverage. Investopedia defines leverage as resulting “from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital.” For real estate, this means acquiring a mortgage from the bank in order to find a house in an attempt to profit from it.
An Example Of Leverage
Now, let’s say Emily and Jeff each buy a rental property for $200,000. Jeff decides to buy his property completely with cash. Emily, on the other hand, decides to buy her property with a down payment of 20% or $40,000. Jeff and Emily both bought houses in an exceptional area where house values increased 10% or $20,000 over the next three years. Now, both Emily and Jeff’s homes are worth $220,000 each. Jeff received a 10% return on his investment over of course of three years. On the other hand, because Emily only invested $40,000, she received a 50% return on her investment in three years. Emily invested less money and still received the same gain as Jeff did.
Sadly, there is a larger risk of investing with leverage. If we take this same example, but instead of the 10% gain in the market, there was a 20% decline in the market, Jeff would've lost 20% ($40,000) of his $200,000 if he were to sell. Emily, because she only invested $40,000, would have lost her entire investment if she were to sell.
Why Leverage Isn’t As Risky As You Think
In the second example, both Jeff and Emily were only going to lose money if they were to sell their investments. If you buy and hold real estate for a long period of time, the short term fluctuations will not make as much of a difference in the house price because the market will always correct itself if it gets too over or under priced.
The Best Real Estate Investment Strategy
Let’s say the real estate market crashes before Emily decides to invest in a property. The property that used to be $200,000 is now selling for $100,000 because the market crashed and the seller is desperate for money. If Emily buys this property for $100,000 with a 20% downpayment, she will be invested in the property with only $20,000. Now, let’s say in six years the property value corrects itself back up to $200,000. Emily would have gained $100,000 on her $20,000 investment, which would come out to be a whopping 500% return.
Many millionaires acquired their status through leveraging with real estate during market crashes. John D. Rockefeller once said, “the time to buy is when blood is in the streets.” What he means by this is that the best time to buy is when everyone is screaming sell. This is what wealthy individuals do. They buy when the prices are low and everyone is wanting to sell.
Disclaimer: I am not a financial advisor, so please review all of this advice with your CFP or financial advisor first.