The power of leverage: Strategies for investment income

Imagine you’re an investor interested in purchasing a rental property. You have two options: you can buy the property outright with your own funds or you can use leverage by taking out a mortgage to finance a portion of the property’s purchase price.

Example 1: Buying Property Without Leverage

Let’s say you decide to buy a property for $300,000 using your own funds. Over the years, the property appreciates in value by 3% annually, and you’re able to charge $1,500 in monthly rent. In this scenario, your investment is fully unleveraged, meaning you haven’t borrowed any money to make the purchase.

After 10 years, the property’s value would have appreciated to approximately $406,569. Meanwhile, the rental income you’ve received over the years would have added up to $180,000. So, your total return would be $586,569 ($406,569 from property appreciation + $180,000 from rental income).

Example 2: Buying Property with Leverage

Now, let’s consider a leveraged scenario. You decide to put 20% down ($60,000) and take out a mortgage for the remaining 80% ($240,000) to buy the same property. You’re able to secure a mortgage with an interest rate of 4%.

After 10 years, the property’s value still appreciates by 3% annually, resulting in a value of approximately $406,569. In this case, your equity in the property has also grown. Your initial investment of $60,000 has appreciated to around $106,569. But what about the impact of the mortgage?

While you had to make mortgage payments over the years, you’ve also benefited from rental income. After deducting mortgage payments and accounting for rental income, let’s assume your net out-of-pocket costs were $20,000 over the 10 years.

Taking into account the property’s appreciation, your growing equity, and the net out-of-pocket costs, your total return in this leveraged scenario would be around $86,569.

Offsetting the Impact of Inflation

In both scenarios, the property’s value has appreciated over time. However, the leveraged scenario allowed you to benefit from property appreciation on a larger investment (the property’s total value) while only putting down a fraction of the purchase price. This is the leverage effect.

Additionally, the rental income in both scenarios helps offset the impact of inflation. As inflation rises, the cost of living and prices for goods and services increase. However, as a landlord, you can adjust the rental income to keep pace with inflation. This means that over time, the rental income from your property is likely to increase, helping you maintain your purchasing power.

In the leveraged scenario, the combination of property appreciation and rental income can work together to provide a buffer against the erosive effects of inflation. While you might have had to pay interest on the mortgage, the growth in property value and rental income can potentially outpace the interest costs, resulting in a net gain.

It’s important to note that these examples simplify the calculations and don’t account for factors like taxes, property management costs, and potential fluctuations in rental income. Real estate investments are subject to market risks, and leverage can amplify both gains and losses. Before pursuing leveraged real estate investments, it’s crucial to conduct thorough research, evaluate potential risks, and consider your own risk tolerance and financial situation.