One of the reasons residential real estate is one of the best investment vehicles available to Australians is because of leverage.
Given the consistent and relatively low volatility returns that real estate provides, lenders are very comfortable allowing a borrower to access up to 95% LVRs.
When you are able to obtain that much leverage, your ROI becomes very high. At the same time, you are also more susceptible if prices fall, which is why it’s important to understand leverage and how it works.
What is Leverage?
Very simply, leverage is borrowing money to invest. A house is a prime example of leverage at work.
In most cases, a bank will require the borrower to put down a 20% deposit on a property and they will lend the remaining 80%.
Banks are comfortable lending to these types of levels because real estate has proven to be a very robust investment over long periods of time.
Contrasting real estate to the stock market and for the most part, obtaining leverage for shares is far tougher. Margin lending is possible but generally speaking most brokers are more comfortable lending to a maximum of 50%, given the significant volatility that we see in the stock market.
What leverage is able to do is increase the total value of the property you are able to control and also increase the returns.
For example, if you want to buy a property for $500,000, then you would be required to put down a $100,000 deposit.
Should that property increase in value by 20%, your cash-on-cash return is actually 100%. As mentioned, the same thing applies should your property decrease in value, which is why you do need to be careful when using leverage.
The time to use leverage is when you are investing 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 is able to get you the thing that you want quicker and easier, 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.
While it’s important to use leverage to purchase high-quality assets, there is risk 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 the boom and bust nature of mining towns.
While mining towns can be attractive because of the high yields they offer and also the possibility of quick and significant capital gains, there is also a lot of risk. 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 very real possibility.
Closer to home, we also see risk when you invest in properties that are not in short supply. The most obvious examples are off-the-plan apartment buildings and also new housing estates on the outskirts of major cities.
Learn more about supply and demand in property investment here.
These investments are all well and good when the property market is hot, but when things turn around, these are the first to fall and the last to recover. They have virtually unlimited supply and can either fall in price quickly or see no real gains for decades. Again, imagine a scenario where you’re highly leveraged and prices are falling.
It’s not uncommon for investors to find themselves in a scenario where they are actually in a negative equity situation and they owe more money to the bank than the house is worth. While it’s not a common outcome, it is very possible and one that you need to 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 at a good price in areas that are ripe for growth.
What that means is you need to identify suburbs that have low levels of supply yet high demand. That’s normally something you can judge by comparing the annual sales (demand) to the number of listings (supply).
To find out the suburbs which have the best and worst levels of demand, download our free pack of suburb reports.
Similarly, buying in well-established areas where there is little room for new properties or developments to be built. Also staying away from regional areas that are based around one industry or even one company (like a mine site) will hold you in good stead.
There’s also always strong demand for properties that are located in areas with good amenities, near rivers and beaches, and in good school zones.
As a general rule, the leverage you get in residential real estate is one of its most powerful elements. However, the onus is on the investor to use that leverage wisely and buy well.