One of the reasons residential real estate is one of the best investment vehicles available to Australians is leverage. Given the consistent and relatively low volatility returns that real estate provides, 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, which is why it’s essential 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 power at work. 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 very robust investment over long periods.
Contrasting real estate to the stock market and, for the most part, obtaining leverage for shares is far more challenging. 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. What leverage can do is 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 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 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 the thing 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.
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 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 properties that are not in short supply. 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 well and 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 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. They owe more money to the bank than the house is worth. While it’s not an expected 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 reasonable price in areas ripe for growth. What that means is you need to identify suburbs that have low levels of supply yet high demand. That’s usually something you can judge by comparing the annual sales (request) to the number of listings (supply).
To find out the suburbs with the best and worst levels of demand, download our free pack of suburb reports. Similarly, buying in well-established areas is little room for new properties or developments to be built. 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 properties 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 potent elements. However, the onus is on the investor to use that leverage wisely and buy well.