This article originally appeared in the Santa Barbara Independent online on May 11, 2008. To see the PDF of the article, click here.
Not a Paid Advertisement. Results May Vary.
By Kevin Bourke
Sunday, May 11, 2008
I see commercials on TV about how to make money in real estate. Do those really work? How
do some real estate investors make so much money?
– Vince from San Luis Obispo
Vince, there are so many programs that promise to make the average person rich, it is hard to know
which one you are referring to. Generally speaking, those programs only work for a very small
percentage of people who try them. The testimonials shown on the TV commercial are the
exception, and usually the disclaimer at the bottom of the screen discloses this.
So then, can the average person make money in real estate? Of course, but how?
There is an unlimited variety of ways to make money in real estate, so let’s just talk about one of
the most common methods. It involves the use of leverage. Leverage is defined as “the use of a
small initial investment, credit, or borrowed funds to gain a very high return in relation to one’s
investment, to control a much larger investment, or to reduce one’s own liability for any loss.”
Let’s see how leverage works in real estate. By the way, this is a hypothetical example and is not
representative of any specific situation. Your results, Vince, will vary:
Joe buys a house and makes a down payment of 20%. Joe rents the house out for enough to cover
his payment. Joe is probably upside down some months because he is responsible for repairs and
maintenance, and occasionally the house sits empty. But he is in it for the long haul, so he keeps it
going like this for several years.
In 7 years, we’ll assume the house appraises for a larger value than his purchase price, so Joe
refinances and pulls just enough equity out to purchase another home. He does the same routine
with this second house, rents it out, hopefully for enough to cover his payment. Note that the rent
on his first house has hopefully increased enough to cover his new higher payment. So, he is still
just covering his cost.
After another 7 years, both houses have appreciated in value. Now he has considerable equity in
each house and does the same thing again. He refinances both, and uses the money to invest in
more property. Except this time, he might be able to afford a down payment on two houses.
So, in year 15, Joe owns 4 houses.
Note that the appreciation on the houses is not based on Joe’s investment, but rather on the sales
price of the house. This is where leverage becomes important. With the first house, Joe actually
invested $50,000, but the house is appreciating based in its sales price.
Now, after 14 years, Joe has built a $50,000 investment into several homes, each of which has the
potential to increase his net worth and contribute to his cash flow.
Vince, there are great risks associated with leverage such as potential adverse real estate market
forces, regulatory changes, and potential real estate illiquidity, and there are no assurances the
strategy’s objective will be attained.
So do your homework, investigate your options, and ask those more experienced than yourself for
help.
