What is the leverage effect in real estate?
In physics, a lever allows you to produce a greater reaction using less force. In investment, the Leverage Effect allows you to produce greater returns using less equity. And the key to it is using debt.
The Mathematics of Investment
Let’s say you buy an apartment for €500K. You provide €300K in equity, and take out a mortgage for the remaining €200K. After 1 year, your apartment has increased in value by 5%, and is now worth €525K. But you have only invested €300K, with the mortgage acting as the lever that allows you to exert greater force. Your returns are leveraged 5:3 (€500K property : €300K equity). Your original mortgage is still in place, at €200K, with payments covered by rental income. However, your property appreciated 5% to €525K, so your new equity is now €325K (€525K - €200K mortgage). This means that the return on your equity is over 8%.
With your mortgage acting as the lever, your equity increases by more than the property value increase.
Now let’s take it further. You provide only €200K in equity, and take out a mortgage for the remaining €300K. With 5% appreciation, your equity is now €225K, and your ROE is 12.5%. After 10 years, the property is worth €815K. Your €300K mortgage is still in place, and your equity is now €515K. Your ROE is 15.75% p.a., and if you sell the property at this time, you can enjoy €315K in capital gains. Additionally, Capital Gains Tax does not apply after 10 years, so that €315K is tax-free.
Obviously these are simplified calculations, and there are certainly costs and risks associated with this approach to the leverage effect. If the value of the property goes down, your equity is just as leveraged, and you can stand to lose a considerable amount of money (this is what happened with the 2008 mortgage crisis). However, real estate tends to be less volatile than most other forms of financial investment, such as the stock market, and risk is lessened over the long term. You just need to be careful that your investments do not leave you over-exposed.
Even without a downturn in fortunes, there are other costs to take into consideration. Closing costs are often not covered by the mortgage, meaning you would have to pay approx. 8% on top of the purchase price yourself. If the property stands vacant for any length of time, and there is no rental income, then mortgage payments and other costs will have to come out of your pocket.
As you make mortgage payments over time, the amount of interest decreases, while the actual amount of the loan you are paying off increases. Eventually the loan is paid off, and you own the full value of the property.
Another key factor which can work in your favour, however, is that when you make a mortgage payment, part of it goes to paying off the interest on the loan, and part pays off the actual loan amount. This means that, as the share of the debt gets smaller, your share of equity in the property further increases.
All of this goes to show that this is a complex situation, with significant upsides. If you need more information, our real estate consultants are on hand and happy to help you. To learn more about the various types of mortgage, as well as the process, check out our article on financing fundamentals, and to find out how much your investment could make, take a look at our return calculator.
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