One of the reasons residential real estate is one of the best investment vehicles available to Australians is leverage. Given real estate’s consistent and relatively low volatility returns, lenders are very comfortable allowing borrowers to access up to 95% LVRs. Learn more about LVR here. When you can obtain that much leverage, your ROI becomes very high. At the same time, you are also more susceptible if prices fall, so it’s essential to understand the power and how it works.
What is Leverage?
In most cases, a bank will require the borrower to put down a 20% deposit on a property and lend the remaining 80%. Banks are comfortable lending to these levels because real estate has proven to be a robust investment over long periods. Contrasting real estate to the stock market and, for the most part, obtaining leverage for shares is far more rigid. Margin lending is possible, but generally speaking, most brokers are more comfortable lending to a maximum of 50%, given the significant volatility in the stock market. Leverage can increase the total value of the property you can control and increase the returns. For example, if you want to buy a property for $500,000, you must put down a $100,000 deposit. Should that property increase in value by 20%, your cash-on-cash return is 100%. As mentioned, the same thing applies should your property decrease in value, so you must be careful when using leverage.
Good Debt
The time to use leverage is when you invest in an asset that increases in value over time, such as real estate. The opposite of this is using debt to finance something like a car or even a holiday. While debt can get you what you want quicker and more accessible, it comes with a price. In the example of a car, it’s common knowledge that its value decreases rapidly. Not only are you stuck paying off the debt plus interest, but you are also losing money on your investment. Learn more about the different types of debt here.
Buying Wisely
While leverage is important to purchase high-quality assets, the risk is associated with any investment, even real estate. We’ve seen many times in our history where Australian property markets do fall. There’s no better example than mining towns’ boom and bust-nature. While mining towns can be attractive because of their high yields and the possibility of quick and significant capital gains, there are also many risks. We’ve seen properties in mining towns lose more than 50% of their value and take decades to regain their previous highs if they ever do. Imagine a scenario where you purchased a property in a mining town with a very high LVR, only for that property to lose 50% of its value overnight when a mine shuts down. That’s a genuine possibility.
Closer to home, we also see risk when you invest in limited-supply properties. The most obvious examples are off-the-plan apartment buildings and new housing estates on the outskirts of major cities. Learn more about supply and demand in property investment here. These investments are all good when the property market is hot, but these are the first to fall and the last to recover when things turn around. They have a virtually unlimited supply and can fall in price quickly or see no real gains for decades. Again, imagine a scenario where you’re highly leveraged,d prices fall. It’s not uncommon for investors to find themselves in a scenario where they are actually in a negative equity situation. They owe more money to the bank than the house is worth. While it’s not an expected outcome, it is possible and one that you must consider before taking on more leverage than you can handle.
Using Leverage to Your Advantage
The best way to use leverage is to buy properties reasonably priced in areas ripe for growth. That means you need to identify suburbs with low supply levels yet high demand. You can usually judge by comparing the annual sales (market) to the number of listings (supply). Download our free pack of suburb reports to find out the suburbs with the best and worst levels of demand. Similarly, buying in well-established areas leaves little room for new properties or developments. Also, staying away from regional regions based around one industry or even one company (like a mine site) will hold you in good stead. There’s also always a strong demand for propertwiths in good amenities, near rivers and beaches, and in good school zones. Generally, the leverage in residential real estate is one of its most potent elements. However, the onus is on the investor to use that leverage wisely and buy well.
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