Different investment vehicles include options to utilize debt to leverage higher returns; real estate is no different, it’s just more common place to have a leveraged position (mortgage) against the real asset (house). The real property itself is the tangible asset which has inherent value which increases, decreases, and which can be sold. However, the mortgage/note/loan against the asset is the liability; a house that you and your family own is not a liability. The difference between the asset’s real-time value and the current total liabilities against a piece of real estate is the equity you have in the asset. Additionally, real estate can have various ancillary liabilities that spur as a result of the asset. For example, property taxes, a mortgage, and an unpaid mechanic’s lien are all liabilities that result from that one asset – make sure to pay your electrician or they can place a mechanic’s lien on your property for the unpaid balance due! A real estate “guru” who brags about buying $1.0M of residential real estate in the past year but has $1.0M of mortgages isn’t a millionaire, they just have $1.0M of debt (assuming the asset values haven’t appreciated). In fact, taking into account the closing costs for every mortgage and/or refinance, unless the assets’ values have materially appreciated, they may have actually lost money during the process – that doesn’t make for an enticing Instagram post, however. Be very wary of “gurus” with get-rich schemes; they may be the only ones getting rich through advertising money and endorsements.
Alright, time for the good part. So here’s why real estate is a great investment vehicle for using responsible leverage to gain a competitive advantage. Real estate doesn’t double overnight, you can’t buy and sell instantly to convert to cash or near cash equivalents, and you can’t track its price by the second. However, historically, it does appreciate by 2 – 5% per year. You may be thinking, 5% is nothing, you can beat 5% in an sector-tracking index fund in the stock market on an annual basis. But here’s the difference. Your 5% gain is on the total value of the asset in real estate, not on your initial equity investment. Whereas, if you put that same initial investment in the stock market and gained 8%, real estate still wins out as a higher return on your initial investment. Here’s a quick example:
| Real Estate (Rental Property) | Stock Market (Equity Index Investment) | |
| Initial Investment | $50,000 | $50,000 |
| Annual Return | 5% | 8% |
| Asset Value | $400,000 | $50,000 |
| Leverage | $350,000 | $0 |
| Total Equity Gain/Return (1 yr) | $20,000 | $4,0000 |
Real Estate versus the Stock Market
Comparing apples-to-apples with closing costs included in the initial real estate investment, brokerage fees included in the initial stock market investment, and assuming a tenant covered all monthly expenses, the real estate return is 5x the return received in the stock market, even with a lower rate of return. In fact, you would have to obtain a return of 40% in the stock market to beat your conservative return of 5% in real estate. The reason why real estate wins is simple – leverage. Leverage allowed a real estate return on the total amount of the asset, versus solely a return on the equity when invested in the stock market. And here’s the best part – this is any extremely conservative baseline example of the power of leverage and real estate. The goal of rental properties is to cash flow while the asset increases in value, not just have your expenses covered each month. Accordingly, if the rental property in the above example was cash flowing $1,000 per month, it makes the total return real estate return increase to $32,000 or an annual return of 64% on your initial investment of $50,000!
A quick clarification on terms. I use return on investment (ROI) versus return on equity (ROE) because ROI is a baseline, all-inclusive number, that includes closing costs and all-associated expenses to secure a piece of property – it is locked-in and remains unchanged (unless you refinance), which allows a useful number to compare to other potential investment opportunities. ROE, on the other hand, includes the equity of the property only, is not inclusive of closing costs, and will technically decrease as the equity position in the property increases (asset value increases); ROE will show a decreasing return as the property rises and will constantly move on a sliding scale.
In closing, a conservative, feasible, and attainable real estate rental property investment can have a 5x or greater return on your initial investment, when compared to investing in a sector-wide index fund in the stock market. Of note, this example assumes no leverage is taken with the initial stock market investment. Margin accounts exist where you can make leveraged purchases of stocks, but usually at a higher interest rate (3 – 4x the rate of a mortgage). Additionally, margin accounts require a minimum equity balance or stocks will be liquidated by the brokerage on your behalf to re-coup their debt. It adds a layer of complexity that isn’t required for a baseline example. See my next post for mortgages and rate shopping!