Use leverage to boost your returns
BY LISA SCONTRAS
Developing a good investment strategy is complicated, especially in tough economic times when every penny counts. Many have learned the hard way – that putting all your eggs in one basket isn’t a good idea – and are seeing the advantages of adding real estate to their investment holdings as a way to diversify. Real estate investors can then build long-term wealth using leverage to boost returns.
“Leverage means investing with borrowed money, so the total return on your own money is magnified,” says Ken Miller, senior vice president of the Investment Services Department at First Hawaiian Bank. “For the average investor, real estate may be the easiest area to use leverage.”
Here’s how it works: Let’s say you have $100,000 to invest, so you pay cash for a small condo that appreciates 10 percent after a couple years. Your return on investment would be $10,000.
But what if you put that same $100,000 down on a home for $500,000. If that house increases in value to $550,000 – the same 10 percent increase – your return on investment is 50 percent, because your initial investment was $100,000. You receive a rate of return on the total value of the home, even though actual cash used to purchase that home was only the 20 percent down payment.
Thus, leverage is a way to increase your profits with the same initial investment.
Of course, using leverage will leave you with a monthly mortage to make, but, as Miller points out, this expense is partially offset by the tax write off on the interest you pay – interest that is now at a new all-time low.
“Mortgage interest payments are mostly tax deductible,” says Miller. “And, if you later decide to trade up, buy and move into another home, the capital gains are generally not taxed up to $250,000 for a single taxpayer and $500,000 for a married couple, which is another reason investing in real estate makes sense.
In addition to using borrowed money, there are additional favorable tax incentives, including saving on capital gains and other tax deductions – economic benefits unique to real estate and sometimes overlooked when analyzing and evaluating investment options.
“You can buy stocks and bonds on margin, but you can’t borrow so much relative to the cash you put down,” says Miller. “Plus, it’s risky, because if the value of the stocks/bonds you buy go down, you may be forced to pay back the loan just when you don’t want to.
“All investments have their advantages and drawbacks,” Miller continues. “The stock market has had higher long-term returns historically, but it’s very volatile in the short term. It’s best to have a mixture of investments. Because real estate performance does not correlate well with the price of stocks and bonds, it is a useful diversifier and hedge against inflation.”
National and local housing data shows that real estate prices tend to correlate with but rise a little faster than inflation.
Where you invest your money largely depends on your personal circumstances and how much risk you are willing to take on. Current market conditions – with low inventory, low-interest rates, stable prices and low days on the market – show a strengthening on Oahu.
“The recovery is occurring despite excessively tight credit conditions and higher down payment requirements, which are negating the impact of record high affordability conditions,” says Lawrence Yun, National Association of Realtors chief economist.
Today’s low-interest rate environment increases return on investment further.
“It can make mortgage payments more attractive compared to renting,” says Miller.
While there is no secret formula that will guarantee your investments will prosper, the practice of reducing risk by diversifying, or buying a variety of different assets, is a good way to limit your losses while maximizing returns. Leverage, or using other people’s money to increase the value of your own investment portfolio, is a wise way to make your hard-earned dollars work for you.
It makes dollars – and sense.