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Lenders typically finance investment properties with down payments of just 20–25% of the sale price. When buying a primary home, the down payment requirements can be significantly lower (although you may have to pay mortgage insurance with less than 20% down).
The effect of this leverage is that small returns can be greatly amplified. Consider this simplified mathematical example. Let’s say that you buy an asset for $100,000 in cash and its value increases by 3%. You earned a $3,000 (3%) return on your investment.
On the other hand, let’s say that you buy a $500,000 asset by investing $100,000 of your own money and borrowing the other $400,000. If the value of this asset increases by 3%, you’ll have a return of $15,000, or 15% of your initial $100,000 investment.
This isn’t a perfect example. When it comes to real estate, you’ll typically have to pay an origination fee to a lender as well as various closing costs when you buy a property. These costs eat into your returns. Plus, if you borrow money to buy a property, you’ll need to make mortgage payments each month while you own it. That said, leverage can still dramatically amplify real estate returns, which is why most investors choose to use it.
The second reason why investment real estate can produce strong returns is that investment properties can be rented out to generate income. To give a personal example, I recently bought a triplex as an investment property. It would be nice if the property value went up over time. But the primary driver of my returns is likely to be the rental income collected from the three apartments.
Finally, real estate investors enjoy tax advantages that stock investors don’t. For example, when you buy an investment property, you get to write off the purchase price over a certain number of years — a tax deduction known as depreciation. It would be awesome if you could write off your stock investments in a similar manner, but that isn’t the case.
Real estate investment trusts, or REITs, get an extra tax benefit in that they avoid corporate taxes by paying out most of their income as dividends. These are easy for investors to buy in an IRA or other tax-advantaged retirement account, meaning they can avoid dividend and capital gains taxes altogether.
As we’re about to see, the combination of rental income, leverage, and tax benefits can combine to produce attractive long-term gains.
How has investment real estate compared with stocks over time?
It’s difficult to find reliable historical data on total returns from individual investment properties. There are too many variables, and there’s no reliable way to track total returns achieved by individual investors.
However, one good way to visualize the power of real estate investments is to examine how real estate investment trusts have performed over time.
With that in mind, here’s a comparison of the total returns of the S&P 500 stock index and the Vanguard Real Estate mutual fund, a good benchmark index of equity REITs: