I was incredibly excited to write this week’s blog post on leveraged appreciation because I thought I had coined the term! Then I did my homework and discovered a previous article published on it (see below), so I am disappointed, albeit pleased that others also view this concept as noteworthy.
I knew a deeper dive was necessary, after having received feedback from last week’s post on REITs versus other ways to invest in real estate and the various ways real estate provides a return on your investment.
First of all, my feelings on appreciation are as follows: We are conditioned to make purchases for appreciation or capital gains – “buy low, sell high” – when we really cannot rely on appreciation to occur in a predictable fashion. We’re fortunate if it happens; at the same time, no appreciation is better than negative appreciation.
Cash flow is predictable; appreciation is not. Our monthly expenses are predictable, for the most part. Real Estate, as an investment, should be purchased for the cash flow it produces, not for the appreciation it might experience. If you buy and the market trends upward, congratulations! That should be icing on the cake, if you bought correctly. If you buy and the market trends downward, who cares? If the investment was purchased with cash flow in mind, a decline in market values should not have any effect on the value of residential or commercial real estate to a tenant. Certainly, in recessions or black swan events such as a pandemic, there may be exceptions to that statement.
In summary, although I don’t invest for appreciation, I’ll be glad if and when it happens.
Now enter the concept of leverage.
Archimedes (Greek mathematician, physicist, engineer, inventor, and astronomer) said, “Give me a lever long enough and a fulcrum strong enough, and I can single-handedly move the earth.”
Leverage is about doing more with less.
In the example of investment real estate, putting 20% down to the bank’s 80% is a way to leverage your 20% to purchase and control the entire investment. Note that generally, you can’t do this with paper assets. As always, there are exceptions.
What happens when your leveraged investment increases in value? In a robust market, 6% annual appreciation is not unheard of. $100,000 in value becomes $106,000.
But wait – you own and control the entire investment with 80% leverage! That makes the 6% increase in value of the asset equivalent to a 30% return on your skin in the game.
Skeptical? Think of it this way:
If you had $100,000 cash, you could own one such property outright and experience $6,000 in appreciation. Or, you could own 5 similar properties with 80% leverage on each. If they all increased in value, then you would have experienced a 5 x $6,000 = $30,000 (or 30%) appreciation.
See how leveraged appreciation can be a nice tailwind to your other real estate investment returns?
What about negative appreciation? Does leverage affect me this way?
Not exactly. If the value of your investment decreases from $100,000 to $99,000, it declines 1% no matter your degree of leverage. If you owned it outright, your equity would be $99,000. If you had 80% leverage, your equity is now $19,000 and you now have 81% leverage.
Leverage amplifies your return from appreciation on the upside and has no effect on your return from other areas on the downside.
What about all the real estate owners who were over-leveraged and lost everything during the recession? Are you telling me being over-leveraged wasn’t the straw that broke the camel’s back?
It probably was, but not in the way you are thinking.
The more leverage you have on an investment (the higher your mortgage payment), the higher the likelihood that you will have a negative cash flow on that investment. If you invested for appreciation and felt that you could sustain negative cash flow in the short term, then had unexpected vacancies, and perhaps had multiple properties affected in this manner, you would have a problem on your hands.
This reminds me of Warren Buffet’s famous quote: “When the tide goes out, everyone gets to see who’s been swimming naked.”
As you think about that, remember to invest for cash flow, but consider leveraged appreciation as part of your overall real estate portfolio return. It’s a type of return that other asset classes don’t enjoy.
Until next time,
Dr. Lee Newton
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Disclaimer: I give ideas, not advice.
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