The Magic of Leverage

[Masa Don]

Thought this might be a good topic in these declining times. . .

The question is how much of your real estate investments should be leveraged?

[Jon Holdman]

Its worse than that once you include transaction costs. Say it costs you $3000 (with origination fees) to by that house. If you sell for $125K, and it costs you $8000 to sell, your net gain is $14K on a $25K investment. 56% ROI, which may or may not be good depending on the length of time.

If it falls by even 10%, though, and costs you $7200 to sell, your net loss is $20,200. An 81% loss.

Historically real estate has just matched inflation. Look at the Case Shiller home price data for the period from the end of WWII to the start of the bubble. After the costs for buying and selling, real estate by itself will lag inflation.

Leverage gives you the possibility of beating inflation. But, as this example shows, it also give you the ability to hurt yourself. If you're at 100%, or even over 90%, you have the possibility of having to pay to get rid of a bad investment. As many, many people are finding out.

I'll also add that I put more stock in the Case Shiller data than in NAR data. Case Shiller gives price trends for the same property over time. NAR data gives trends for median home prices. The median house price trend is not the same as the what you can expect for appreciation of a specific house. If the mix of houses changes, which does appear to be the case since most new houses are bigger and nicer than most "post war ranches", then the median priced house trend will be higher (faster appreciation) than the price trend for individual properties.