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| Is leverage (putting down as little money as possible when buying a home) the key to real estate profits? Experts take opposite sides. |
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| On the one hand, Gary W. Eldred, who wrote The 106 Most Common Mistakes Homebuyers Make, argues in favor of leverage. |
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| For example, 3% appreciation on a $200,000 home yields $6,000. Against the $20,000 down payment, this yields 30 percent in the first year. |
On the other hand, Steve Lyons, who wrote HomeBuyer, says when you take into account the financing cost of the mortgage, the claims made in favor of leverage are bunk.
Is equation 2 suggesting leverage has nothing to do with profit? Yes! Is equation 2 suggesting these real estate experts from time immemorial are wrong? Yes!
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| This is an important issue. For example, the "no money down" theory of real estate investing depends heavily on the idea that leverage magnifies profits. (Apart from the leverage controversy, one problem with the theory is people who will sell you real estate with no money down may not be as dumb as you think. They may inflate the price of the property, from say, $85,000 with a normal purchase, to $120,000 where the seller lends you all the funds with no money down. As a result, you would find yourself with a debt of $120,000 on a house with a market value of only $85,000. As long as you meet your monthly payments, the seller is earning a nice profit, and your only exit is to go into default and let the seller foreclose and get the property back.) |
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| More generally, it may make sense to take the side against the "no money down" people and against others, like Gary Eldred, who make misleading claims about the value of leverage. In Eldred's example, against the $6,000 you earn from the appreciation of the house you have to net out the interest cost of the mortgage, as well as the interest that you might have earned by investing the $20,000 in another asset. |
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| As Lyons points out, when you take into account the interest costs, it works out that the amount of leverage you have makes almost no difference to the value of investing in real estate. That is, if one person pays $180,000 up front for a $200,000 house and another person pays $20,000 for a $200,000 house, and both houses appreciate at the same rate, in five years the two people will be in about the same financial position. Yes, many factors can cause their results to differ in various ways, but the low-down-payment investor does not end up nine times wealthier than the high-down-payment investor, as the Eldred-type calculations imply. |
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