Monday, December 28, 2009

Wealth Creation, part 2: Real Estate as a meaningful component of your portfolio

Why is it good to have Real Estate as a part of your portfolio?

There are several reasons, but the main differentiator between real estate and other investments is Leverage.  What is leverage?  It's also called Other People's Money (OPM) and probably other things.  Leverage is buying an asset by putting a small (or large) fraction of the money down yourself, and borrowing the rest.  This means that not only is your money working for you but other people's money is working for you too.
When you invest in the stock market, your money is working for you, and you'll see increases of 8, 10, maybe even 12% per year on your initial investment.  In real estate, you put a down payment (the standard is 20%, but I've bought houses before with as little as 3% down (although this is harder today than it used to be).

Let me give you an example:

I have $10,000 to invest.  I can do one of two things with it.

1) I buy a Dow Jones Industrial index fund with my $10,000.  The stock market has an exceptionally good year and increases 15%, and I end up next December with $11,500.  My return on investment is $1,500/$10k = 15%.

2) I use my $10,000 as a down payment on a $50,000 house.  I borrow the other $40,000 from the bank (OPM).  In the next year, the house appreciates 5% (a realistic appreciation historically) and the house is worth $52,500.  I still owe $40k (well, probably more like $39,500 because I've paid down a little bit of principal).  So my equity (defined as the value of the house minus the mortgage) is $52.5k - $39.5k = $13k.  So my Return on Investment is $3k/$10k = 30%, twice the return of the optimistic stock in the example above.

One could get even more aggressive, and take the $10k and split it and buy 2 houses, with $5k (10%) down each.  If each of the houses increased by 5% to $52, 500, the total would be $105k.  So your return on investment would be $5k/$10k = 50%!  The more leveraged you are, the better the return.

To be completely transparent, leverage can work against you too (as it did with many people in the last year of economic downturn) if the value of the house went down 10% from $50k to $45k in example 2, you would have lost half of your down payment, and you would be down from $10k equity to $5k, or a 50% (unrealized) loss.  So what do you do if this happens?  Nothing!  Real Estate has gone up over any 5 year period over the last 100 years.  So you should just keep collecting rent, keep making your mortgage payments and wait it out.

Next post: What is cash flow?

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