Friday, December 7, 2012

How Does Leverage and Debt Impact Returns on Residential Real Estate?

As a speculative investment, residential real estate has the potential to make or lose vast sums of money due to the impact of financial leverage (debt). Houses are typically leveraged at 80% of their value. During the Great Housing Bubble, this leverage was often provided at 100% by various lenders.

Leverage is a powerful ally when prices increase, but leverage works just as strongly against the speculator when prices decrease. For example, if a house is leveraged 80% and it increases in value 5% in one year, the return to the investor is actually 25% due to the 5 times multiplier created by leverage.

With the effect of leverage, speculation on housing can far exceed any competing investment strategy. However, the inverse is also true. If a house is leveraged 80% and it decreases in value 5% in one year, the loss to the investor is 25% of her downpayment, not just the 5% the house declined in value. Leverage magnifies both the return and the risk of any speculative venture.

One of the worst mistakes lenders made during the Great Housing Bubble was to allow 100% financing and negative amortization loans. This was a boon for speculators because it allowed them to participate in the market without any of their own capital and it allowed them to hold the speculative assets with a minimal debt service expense. Plus, there was the implicit idea that they would simply default if the deal did not go in their favor (which of course many did).

Combine these facts with the near elimination of loan underwriting standards allowing anyone to participate, and the conditions were perfect for rampant speculation, a wild increase in prices and so much speculative demand that many new and existing home purchases would remain vacant.

Leverage is a tool. It magnifies the return on investment in both directions. When prices are steadily rising, people want to use as much debt as possible to obtain the asset in question. When prices drop, heavily leveraged speculators get completely wiped out.

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