Financial leverage is probably the greatest wealth creation tool in real estate investing. Yet few understand leverage until they watch this.
Keith Weinhold: Hi, my name's Keith Weinhold, and this is Get Rich Education. Most people know that real estate has created more wealth for ordinary people than any other investment vehicle, but most people just don't know how. One big reason how real estate investors get ahead is through something called financial leverage. The good news is financial leverage is available to everyday people. It's available to you.
I think the best way to understand leverage is for us to compare what a stock does over a typical year versus what a real estate investor does over a typical year. The best way is to look at this example of financial leverage. Leverage is simply the ability to do more with less. If we go ahead and take a look at what a typical stock investor might do, a stock investor that doesn't typically have access to leverage like a real estate does, is they might invest $100,000 in a basket of stocks.
A real estate investor at the same time, they will go ahead and invest $100,000. That's the purchase price for an income property. You want to pick that property carefully. You want a property where the monthly income exceeds the monthly expenses. Let's take a look at the typical gains for the stock investor versus the real estate investor.
A stock investor's gain might be about 10%. That's the average return of the S&P 500 over the long term, so this stock investor gained $10,000 in that first year. The real estate investor, they didn't gain as much. They gained $6,000, because 6%, more or less, is the long-term appreciation rate of real estate nationally and historically.
The stock investor, they had to go ahead and invest $100,000 in stocks in order to get $100,000 worth of stocks. The difference is, with the real estate investor, they have the ability to get a loan. Typically for a property that you intend to rent to somebody else, you can put a 20% down payment on that property. The real estate investor often just has 20k of skin in the game.
Let's look at the return on investment after one year. The stock investor had a $10,000 gain divided by $100,000. That's our ROI formula. a 10% ROI is what that stock investor experienced after year one, but with the real estate investor they had a gain of only $6,000 divided by only $20,000. That's all that they have tied up in the deal. For the real estate investor, they have a 30% rate of return after year one.
How exactly did that happen? That happened because the real estate investor gets a return on both the portion that they put in as a down payment, the $20,000, and they leveraged $80,000 from the bank through a loan in order to control a $100,000 property. That $80,000 payment is serviced by tenent rent income.
30% for a real estate investor versus only 10% for a stock investor, but we're not done. We want to think like an investor. Typically there's inflation over time. The rate of inflation is typically higher than what the government reports, so a 5% rate of inflation is really what we want to do to adjust our rate of return. If we knock 5% off this, that's a real return on investment of 5% for the stock investor versus 25% for the real estate investor.
In real terms, when we've adjusted for the prosperity due to the diminished purchasing power of the dollar over time, real estate beats stocks five-fold. Additionally, this is one of only five ways that a real estate investor is paid simultaneously. Now there are some caveats around this. There are some things to be careful for. On the contrary, there are also some ways to optimize this leverage for a real estate investor.
This is something I wish I would have known about sooner, frankly, but I've been doing it successfully as an active real estate investor for 14 years. You can check out more of my resources at getricheducation.com. I also host the weekly Get Rich Education podcast where you can hear me each week on iHeartRadio and iTunes. I'm also an active contributing writer at the Rich Dad Advisor's Blog. Again, my name's Keith Weinhold. Thanks so much for stopping by.