Introduction: The Power of Leverage

Understanding leverage and utilizing it in your investment strategy is a crucial aspect of real estate investing. Leverage, simply put, is the use of borrowed funds to finance the purchase of an asset, with the expectation that the profit made from the asset will be higher than the interest on the debt. In this article, we will delve deeper into how leverage works when buying rental property and what a 30-year investment outlook looks like with a 4% historical annual appreciation rate on real estate.

Leverage Example

To illustrate how leverage works in real estate investment, let’s take a hypothetical example of John, a young professional looking to invest in a $500,000 rental property. Let’s say John has $100,000 for a down payment, which equates to 20% equity in the property, and borrows the remaining $400,000 at a fixed interest rate of 6% per annum. He expects rent from the property to cover his monthly mortgage payments, maintenance costs, and provide a modest cash flow. 

So how does leverage factor into this scenario? Let’s fast forward to 30 years later. Assuming a consistent 4% annual appreciation rate of real estate, John’s initial $500,000 property would now be valued at approximately $1,622,000. After 30 years, John owns the property outright, meaning his initial $100,000 investment has grown into a $1,622,000 asset. This equates to a whopping 1,122% return on his initial investment, yielding over 11X the initial investment.

Notably, leverage has allowed John to control a $500,000 asset with just $100,000 while reaping the full benefits of appreciation on the whole property value. Also, the rental income has enabled him to service the loan without making any out-of-pocket expenses. 

Should John have chosen to purchase a property outright, his $100,000 could only afford him a much cheaper property, limiting his appreciation returns and rental income potential. Leverage, therefore, significantly magnifies John’s investment impact and overall returns.

Using leverage when investing in rental properties can yield substantial returns over time, granted the real estate market continuously appreciates. Ensuring that your calculated rental income could cover mortgage payments, maintenance costs, and ideally offer a positive cash flow, will make the investment worthwhile.