Leverage in Real Estate Investing

For most people, DEBT is something to avoid and to payoff.   However, just like cholesterol in your body, there is GOOD DEBT and then there is BAD DEBT.

BAD DEBT is  purchasing things (depreciating assets) with other people’s money, such as credit card debt and car loans

GOOD DEBT is purchasing investments (appreciating assets) with other people’s money, such as real estate and stocks.

*Student loans* can fall into either category, but usually falls into GOOD DEBT, as one’s education is an investment into one’s career (although this could be debatable depending on field of study)

The key to why real estate investing is a powerful investment vehicle is LEVERAGING.  Leveraging is using GOOD DEBT to purchase real estate.   You are using the bank’s (or private loans) in the form of a mortgage to invest in real estate.

Example:

You have 1 million dollars to invest.   You purchase a house for 1 million dollars (ignore closing costs for simplicity), and rent it out to a tenant.   After 1 year, the house value in the area  has increased by 10% (not unheard of in cities like Vancouver or Toronto).   So your return on investment (ROI) based only on appreciation (ignore cash flow and mortgage paydown) is 10% or $100,000.  Not bad right?

Let’s see what a sophisticated real estate investor would do with that 1 million dollars instead.

He/she purchases 5 houses, each priced at 1 million dollars, by putting $200,000 down paymentstowards each house, and then takes out $800,000 mortgages (GOOD DEBT) on each of the house, and then rents each house to tenants (again, ignore closing costs).  The tenants are paying down the GOOD DEBT for the investor.  After 1 year, the house value in the area has increased by 10%.  So your ROI based only on appreciation (ignore cash flow and mortgage paydown) is 10% ($100,000) x 5 houses = 50% or $500,000

$100,000  (10%) vs $500,000 (50%).    This is the power of LEVERAGING.

LEVERAGING of GOOD DEBT to increase your ROI is what powers real estate investing.   To be a sophisticated real estate investor, you need to understand and become comfortable with this concept.

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