The common misconception around investing in real estate is with regards to the annual returns on the investment. When compared to the average appreciation of stocks, the average appreciation of real estate is usually a lot lower (somewhere around 7% vs 3% as a national average). But here is why investing in real estate can be BETTER than investing in stocks.
Leverage
Aside from all the psychological and emotional benefits of homeownership, the high prices of homes might scare you away. You might even be turned away by the high price-to-rent ratios.
But let’s take a simplified version of a story to understand how leverage can play a huge role in making a real estate investment worth it.
By the logic of just pure appreciate rates, if you invest $100,000 in stocks, you can expect to have $107,000 in worth by the end of the year. If you invest $100,000 in real estate you can expect to have $103,000 in worth by the end of the year.
And this is where everything change.
With real estate, you have the opportunity of taking out a loan to finance your home. Rather than putting up $100,000 on your property, you could put down only 20% of that (which comes up to $20,000).
Leaving closing costs and mortgage interest rates out of the equation for simplicity, at the start of your homeownership journey, you would have put down $20,000 and would be owning a $100,000 property. At the end of the year, assuming this property appreciates by 3% as well, the property’s worth is now $103,000.
You have gained $3,000 in capital gains over the year because the 3% in appreciation applies to the TOTAL worth of the property, NOT the value on which you put upfront when buying the home.
In very simple terms, if you were to sell this home instantly, you’d cash out at $103,000. Since you owe the bank $80,000, you’d be left with $23,000. Within a year, you’ve gained $3,000 on your initial $20,000 investment. This is a whopping 15% return on your investment! That’s more than twice what you would have gotten on your investment in stocks, and you did so with just 1/5 of the money you needed to invest in stocks!
Of course, the scenario above is crudely simplified, because we left out two of the biggest factors that change this equation, ie. closing costs during the buying and selling process, and mortgage insurance rates (we also didn’t cover taxes which might or might not help you financially, but we’ve talked about them in detail before). These are very dependent on the market and timing, so you would have to run the numbers yourself to find the breakeven point for when would be the best time to buy/sell, and how much to put down (the larger amount you put down, the lower your risk but the lower your rewards as well).
We hope you understand better how leveraging your financial investments could put you in an amazing position, one you might not have understood fully before!
