The power of leverage

Here is a simplified example to illustrate how leveraging borrowed money for an investment property can potentially increase your yield compared to a simple bank deposit. We'll look at a 5-year timeframe. In this example, under the assumptions as illustrated below, the investor would have significantly outperformed the bank deposit. The assumptions and workings are as follows: 

Assumptions: 

• Property Value: $650,000 

• Deposit (10%): $65,000 

• Loan Amount: $585,000 

• Interest Rate on Loan (Year 1): 6% (Assumes interest-only loan for simplicity in early years) 

• Rental Income: $620 per week ($32,240 per year gross) 

• Property Value Appreciation: 6% per year (compounded) reflecting a similar appreciation rate as the past 25 years 

• Expenses: 20% of rental income goes to expenses (property management, maintenance, etc.) leaving Net Rental Income at 80% of the gross. 

• Bank Deposit Alternative: $65,000 invested at a 4% annual interest rate (compounded) 

• Inflation: Negligible inflation to keep the math simple 

Scenario 1: Investment Property (Leveraged) 

• Year 1: 

• Gross Rental Income: $32,240 

• Net Rental Income: $25,792 (80% of gross after expenses) 

• Interest Paid on Loan: $35,100 (6% of $585,000) 

• Net Cash Flow (Year 1): -$9,308 (Rental Income - Interest) 

• Property Value Appreciation: $39,000 (6% of $650,000) 

• Year 5: 

• Property Value: $868,650 (compounded 6% annually) 

• Total Appreciation over 5 years: $218,650 

Financial Outcome for investment Property after 5 years: 

• Net Cash Flow Loss after 5 years: $46,540 (5 * -$9,308) 

• Equity Gained Through Appreciation: $218,650 

• Total Financial Outcome: $172,110 (Equity Gain - Cash Flow Loss) 

Scenario 2: Bank Deposit (No Leverage) 

• Year 5: 

• Value of Bank Deposit: $79,065 (compounded annually at 4%) 

Comparison After 5 Years: 

• Investment Property: Total Value Gained $172,110. 

• Bank Deposit: Total Value Gained $14,065. 

Key Observations & Caveats: 

• Leverage Amplifies Gains (and Losses): The property investment potentially outperformed the bank deposit due to the appreciation of the entire property value, even though you only invested 10% of it. The debt made that possible. 

• Cash Flow Can Be Negative Early On: In this simplified example, the interest payments significantly impacted the cash flow in the early years. This can be a major challenge for investors. Short term pain for long term gain. 

• Interest Rate Sensitivity: If interest rates rise significantly, the interest payments could eat up more of your rental income and erode your profit. 

• Vacancy Risk: The example assumes the property is always rented. Vacancy periods would reduce your income. 

• Simplified Example: This is a simplified model. It doesn't include: 

• Taxes: Property taxes and income taxes on rental income can significantly impact returns. 

• Capital Gains Taxes: When you sell the property, you may owe capital gains taxes on the profit. 

• Transaction Costs: Buying and selling property involves significant costs (legal fees, agent commissions, etc.). 

• Loan Amortization: I assumed interest-only for simplicity. Principal repayments would reduce your debt but also impact your cash flow. 

• Unexpected Repairs: Major repairs can be costly. 

In Conclusion: 

Leveraging debt to invest in property can potentially increase your returns compared to a simple bank deposit, if the property appreciates and your rental income covers your costs. However, it also introduces significantly more risk. Interest rate changes, vacancy periods, and unexpected expenses can quickly turn a profitable investment into a losing one. 

Important Disclaimer: This is a simplified example for illustrative purposes only and should not be considered financial advice. Real estate investment involves significant risks, and you should consult with a qualified financial advisor before making any investment decisions.