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Leverage: Home Appreciation vs. Investment Perfomance

Written by Nickel - 28 Comments

Not long ago, I put together a historical graph of our net worth. In response to this look back at our financial performance over the past decade, mbhunter asked how much of the increase in our net worth was due to appreciation in home value. My response was that our first house appreciated at roughly 7%/year for the four years in which we lived in it (2002-2006; we haven’t been in our new house long enough for it to have appreciated much at all). But all of this got me to thinking…

While the value of our home increased at 7%/year, this vastly understates the performance of our home from an investment perspective. The reason for this is that we invested far less than the the cost of our home when we bought it, and we used borrowed money (i.e., a mortgage) to cover the rest. In the investing world, the use of a small initial investment combined with borrowed money to finance an investment is referred to “leverage,” and it can dramatically amplify your investment performance.

Here’s the situation:

Our house cost roughly $180,000 when we purchased it, and we sold the house after almost exactly four years for roughly $240,000.

Now for the math:

A $60,000 profit on a $180,000 purchase is a 33% increase. Compounding that out over four years, it comes to just under 7.5% per year. Of course, that’s a bit generous, as we had costs associated with selling at the back end. Factoring in a 6% commission on the selling end, we cleared $225,600 for a profit of $45,600. This is just over a 25% gain, or just under 6%/year. Not too bad, especially considering that: (1) we weren’t in an overly-hot housing market, and (2) it was a tax free gain. But wait, it gets better…

When we bought our house, we didn’t pay cash. Rather, we took out an 80% mortgage with 10% down ($18,000) and another 10% from a second mortgage. We were, however, able to kill off the second mortgage in relatively short order (i.e., within about two years). Thus, for the sake of simplicity, let’s assume that our amount invested over our time in the house averaged $27,000 ($18,000 for the first two years and $36,000 for the last two years). Let’s just call it $30,000 to account for a small amount of closing costs.

Since the alternative to buying a home would’ve been to rent, and because a suitable property would’ve cost about the same as our mortgage payment (including taxes and insurance), I’m going to simply ignore our monthly mortgage payment for the purposes of this calculation — after all, we would’ve been writing a check of that same amount every month, whether it was to a bank or a landlord.

So… We actually banked a $45,600 tax-free profit on a four year investment of (roughly) $30,000. That’s an overall gain of 152%. Compounding that out over four years, we actually earned 26% per year on our investment.

Had we put even less down on our house, the percentage returns would’ve been even higher. This is exactly why you always see late-night infomercials touting “no money down” real estate investment. The thinner you spread your money, the more leverage you’ll have, and the higher your potential returns will be. Unfortunately, this sort of leverage can really amplify your risk, as well. Buying a house for yourself is one thing, but loading up on property (or any other investment) with minimal money down is an entirely different kettle of fish.

Published on July 23rd, 2007 - 28 Comments
Filed under: Real Estate, Saving & Investing

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28 Responses to “Leverage: Home Appreciation vs. Investment Perfomance”

  1. 1
    Kurt Says:

    “We actually banked a $45,600 tax-free profit on a four year investment of (roughly) $30,000. That’s an overall gain of 152%. Compounding that out over four years, we actually earned 26% per year on our investment.”

    That is the wrong way to look at it. If you are going to allow yourself the benefit of leverage, you have to factor in the cost (interest expense). I think you probably paid ~$40k of interest, so your total return on the house was probably less than the 26% you show above.

    Heck, with a return on capital of 6%, you probably would have lost money had you levered it 100% (though rates were quite possibly much lower when you took out the loan).

    You must compare apples to apples, my friend.

  2. 2
    ntguru Says:

    Technically, Kurt is right. But there is some grey area here which essentially boils down to can mortgage expense (ie interest) be excluded because the same amount would have been paid as a rent expense.

    Certainly if this was a purely rental property you would have to include the interest. However, in that scenario one would presumably have rental income, which would hopefully at least offset the interest portion of the mortgage payment. One could argue that in the first example the “rent payment” is made to yourself (ie you are the renter and the landlord).

    Also, to be fair, you would need to include other upkeep and maintenance expenses.

  3. 3
    Hieronymus Says:

    Re: interest expense

    Yes, he should look at overall expenses, but he also has to live SOMEWHERE, so interest expense is what he paid in lieu of rent, so the math is not quite straightforward.

    Also, don’t discount the tax benefit of interest deductibility (again, it can get quite compicated if the deduction moves you down a marginal bracket–OR causes you to be hit with AMT!).

    For my purposes, excluding the interest-expense effects if likely a conservative approach, given that my overall mortgage payments (*excluding* the beneficial tax treatment) are far less than I would have to pay for an equivalent rental.

  4. 4
    Blaine Moore Says:

    I’ve been in my first house for less than 2 years; I hope that it is more than 2 years before I decide to sell.

    I would offset the interest cost against rent because that money would be spent in either case unless there was no mortgage.

    It serves the same purpose as rent; it gives you a place to live. Without that interest payment, there would be no house unless he had spent a lot of time saving ahead of time…

  5. 5
    nickel Says:

    Kurt: That’s not right. If we hadn’t owned this house, we would’ve rented, and rent for a suitable property was almost identical to our monthly mortgage payment… We would’ve written that check either way, so it’s perfectly fair to exclude that amount when figuring our effective return.

    Looking at it another way, let’s say we broke even after subtracting mortgage-associated costs (interest, from our gain. In that case, we would’ve lived for free for 4 years, but it wouldn’t be fair to say that we didn’t earn anything, as we would’ve effectively earned enough to completely offset four years worth of rent payments.

    ntguru does, however, have a valid point when it comes to maintenance and upkeep. Fortunately, this was a brand new house, and we didn’t actually put too much money into it. But to be perfectly fair, I should’ve reduced our gain by the amount of money we put into maintaining/improving the property (at least to the extent that it would exceed our upkeep costs had we rented instead).

    And hieronymus has a good point with regard to tax deductibility. I called the mortgage vs. rent issue a wash, but the mortgage interest was actually tax deductible, which would make the mortgage payment *smaller* than the rent payment, thereby making my calculation somewhat conservative.

  6. 6
    nickel Says:

    Blaine: That’s exactly my point. And given that our mortgage payment: (1) gave us a tax deduction on the interest portion, and (2) contributed at least a small amount to our equity, then calling it a wash against an equal amount of rent is actually being conservative.

  7. 7
    Brad Says:

    nickel, I did the same kind of analysis on my house and the results are similar. The bottom line: 44% annual gains for two years. It has been a phenomenal moneymaker for me in the 2+ years we’ve been there, and when we sell we will collect a handsome profit.

    I know many people don’t like to consider their primary home an investment, and that’s okay. But I will make the most of it financially, no matter what people wish to call it.

  8. 8
    Kurt Says:

    I understand the issue of you needing to live somewhere. However, that is not relevant when looking at returns figures. For instance, in retirement, you are drawing down on your savings to live. When someone asks you your return on your stock portfolio, you don’t give them the figure after your cash-outs. (in other words, if I buy a stock, it doubles, and then I cash out, I don’t have a negative 100% return)

    As you point out, you have to spend money to live regardless of whether or not you buy a house and it is because of that regardlessability (new word!) that you should factor interest expense into your return on equity.

    “We would’ve written that check either way, so it’s perfectly fair to exclude that amount when figuring our effective return.” If you’re comfortable that your “effective return” is not comparable to investment returns as normally calculated, that’s fine.

    It’s a fundamental theory of finance that you must compare leveraged returns numbers to leveraged capital numbers and unleveraged returns to unleveraged capital numbers. That is why mkt cap / net income and enterprise value / EBITDA are valid valuation metrics but mkt cap / EBITDA and EV / net income are not.

  9. 9
    Kurt Says:

    Should be noted that I’m trying to capture capital appreciation here. Total returns would require an implied rent (even if it isn’t rented out and this number does not equal interest expense — it’s likely higher than interest expense).

  10. 10
    Kurt Says:

    “Should be noted that I’m trying to capture capital appreciation here. Total returns would require an implied rent (even if it isn’t rented out and this number does not equal interest expense — it’s likely higher than interest expense).”

    And reading your post again (maybe I missed this and/or it was added), if you think you could rent it out at the same rate as your mortgage monthly payment, the return on equity is likely in the range you’re looking at.

    Teach me to read quickly first thing in the morning!

  11. 11
    Brad Says:

    Kurt–

    You are trying to make the issue more complicated than it is, IMO. By spending an extra $30k, nickel has gained an extra $45k. That is the bottom line. The return on nickel’s spending is 152%, no matter how you choose to label it. I fail to see how this is different than any other investment return.

  12. 12
    Kurt Says:

    “You are trying to make the issue more complicated than it is, IMO. ”
    All good things in life are complicated. :-)
    See my last post. Doing a proper discounting on this probably yields a number slightly higher than 26% (assuming no upkeep, property taxes, etc).

    It’s the property taxes which really kill real estate in many places. For instance, if this had a 3% property tax rate (as we have here), you can knock $25 grand off the “returns” (tax affected down to ~$17k).

  13. 13
    Brad Says:

    Yeah, I was writing my response when you added that last part. No problem.

    Yes, property taxes and insurance can be a large part of the equation. Here, property taxes are 2.5% but are only assessed on 25% of the tax appraisal value of the home (and this appraisal is notoriously below market value). So our property taxes are quite low. Additionally, homeowner’s insurance is cheap as I live in a relatively “safe” (from natural disaster) area. In Florida, due to all the hurricane damage, insurance is many times what it is here. Both of those factors lead to the conclusion that it “makes sense” as an investment to buy a home here; much moreso than it would in other places.

  14. 14
    Kurt Says:

    “property taxes are 2.5% but are only assessed on 25% of the tax appraisal value of the home (and this appraisal is notoriously below market value).”
    That’s odd. I wonder why they do that (as opposed to just having property taxes be 63 bps of the home’s actual value)?

  15. 15
    Brad Says:

    I have no idea, Kurt. There may be a law on the books here that says taxes can only be assessed on part of the property value, which would force them to work within that framework. I’m really not sure what the origin of that is.

  16. 16
    Kurt Says:

    I figured it out! Something was bugging me about these numbers and my initial read was wrong. When I was driving home tonight I realized that it was the comparison of the levered to the unlevered number that didn’t feel right. Here’s what’s wrong: you include the “implied rent” in the levered return (by virtue of ignoring interest expense) but you don’t include it in the unlevered return! You have to add in 48 months of rent to the first figure (increasing the 7%).

    *That’s* the problem with this post. I just couldn’t figure it out initially.

  17. 17
    J at Home Finance Freedom Says:

    Hello. I largely agree with Kurt about missing or inconsistent costs but there is a bigger issue. Leveraging (v. cash) will LOWER your RATE of return to maximize total dollar profits (increased volume of lower margins) and it only appears to increase the rate here because the leveraging costs were moved “off-book.”

  18. 18
    nickel Says:

    Kurt: I never calculated an unleveraged rate of return. What I was comparing was the home price appreciation vs. the true rate of return on our investment. Nothing more, nothing less.

    Aand as I’ve made clear more than once, I didn’t “ignore” the interest cost. I simply traded it out against what we would’ve otherwise paid in rent. If this was an investment property then I would agree with you that we would explicitly need to account for this, although we would then have been collecting rent to offset at least part of the interest costs. Likewise, if the mortgage payments were less more than rent, then we’d have to correct for that as well. But using the crude assumption that these amounts are equal – in reality, the mortgage payment is more or less the same as what we would’ve paid in rent, although this ignores that fact that a small portion of every mortgage payment actually went toward principal. Thus, I’m actually being conservative by ignoring it.

    Brad has it right. Because this was our principal residence, and because we would’ve otherwise incurred rent in an amount equal to our mortage payment, it’s perfectly fair to view this as a free and clear profit (admittedly, after ignoring a small amount of upkeep/maintenance costs that we incurred).

    Look at it this way. We paid X dollars per month to put a roof over our heads (whether than was rent or mortgage, it doesn’t matter) and we then invested $30,000 for four years and profited $45,600. Whatever we chose to invest in, the numbers work out the same.

    I do realize that I’m making some simplifying assumptions for the sake of convenience. This was also made simpler by that fact that our rent and mortgage costs were a push. But the general approach is valid.

    J: You’re going to have to re-state your criticism more clearly before I can respond to it.

  19. 19
    Hieronymus Says:

    Rats, Kurt beat me to it: if you want to make it GIPS-quality accurate (which is no the goal here, I think), you could view the house as an income property with YOU as the tenant (and set your “rent” exactly equal to home-owner expenses, which is *at least* what you would do were you renting it–the rent would include maintenance, taxes, mortgage, etc…).

    But I think we are getting a little too complicated… While the post was, indeed, about performance, in the larger picture he is more focused on net worth.

    Calculating one’s net worth appreciation over time would be interesting as well…

  20. 20
    Kurt Says:

    “Brad has it right. Because this was our principal residence, and because we would’ve otherwise incurred rent in an amount equal to our mortage payment, it’s perfectly fair to view this as a free and clear profit (admittedly, after ignoring a small amount of upkeep/maintenance costs that we incurred).”
    You misunderstand me. You need to include that figure in the unlevered number as well. In the 7% you are not giving yourself the benefit of equivalent rent while in the 26% you are. When comparing the two, you are not isolating the impact of leverage, you are isolating the combined impact of leverage and equivalent rent.
    Ignore or “trading it out”, it doesn’t matter, in the second case you gave yourself the benefit of leverage without the cost, and therefore, to compare apples to apples, you have to do that in the first calculation as well. I agree that you did it right in the leveraged calc (subject to all the conditions you lay out). But you did it wrong in the unlevered calc.
    Look at it this way: if you had paid all cash for the house, your capital would have appreciated 7% a year, but you would have also had implied income of your mortgage payment (because that is what you could rent it out for, you say). So it’s actually MUCH HIGHER than 7% a year (probably 12%?). So leverage does not bring you from 7% to 26%. Only from 12% to 26%.

  21. 21
    Kurt Says:

    “Leveraging (v. cash) will LOWER your RATE of return to maximize total dollar profits (increased volume of lower margins) and it only appears to increase the rate here because the leveraging costs were moved “off-book.””
    Leveraging will increase your rate of return when the cost of borrowing is lower than the return on capital (this is what through me off here initially–he calculated the return on capital wrong, and at 7% RoC, leverage ain’t going to help you).

  22. 22
    nickel Says:

    Kurt, I see your point. As I noted at the beginning of my last comment, I never really tried to calculate an unleveraged return. Rather, I jumped from straight up home price appreciation, which is what a lot of “average Joes” like me think about when looking at the real estate market, to the “true” performance of our invested dollars. But it seems that you are correct that it’s not fair to say that leverage alone is responsible for the difference between price appreciation and the leveraged return. Thanks for chiming in.

  23. 23
    Brad Says:

    nickel, isn’t it nice to have smart readers such as Kurt? Even if they’re nitpicky. ;-)

    Still, I like the bottom line of the story: that there is more to real estate investment returns than plain vanilla value appreciation, and that the actual ROI is usually substantially better than the rate of appreciation due to leverage and the elimination of rent.

  24. 24
    Kurt Says:

    “Thanks for chiming in.” And thanks for correcting my initial misread.

    Keep up the good work.

  25. 25
    J at Home Finance Freedom Says:

    We are mixing up many things and I am sorry for being unclear. I am in the middle of writing a series of articles about house investments and, to clarify my comment here, I added an article about ROI calculations of leveraging (click name link).

  26. 26
    Mark Says:

    Now that the residential housing market bubble has burst, I’d be interested in seeing this calculation revisited. I’ve been looking at historical price appreciation … and 6-7% per year is looking like a good market compared to historical averages. The picture gets far uglier in a down market like we are currently experiencing … and down markets tend to be persistant for a period of time.

  27. 27
    nickel Says:

    Mark: It’s impossible to revisit it. We sold our house at the prevailing market price at the time, and that situation is all that I was dissecting in this article. Prices in that area have softened, but if we were selling now we’d still be able to get more than we originally paid for it. Given that, leverage still would’ve been to our advantage, as that profit would’ve been based on a smaller investment with a mortgage as compared to without.

  28. 28
    Chris Says:

    I don’t understand that last comment. Your entire premise was based on the $60,000 appreciation on the value of your house. What is the house worth now?

    Leverage only works to your advantage when the average annual return on your investment (ROI) exceeds the APR on the capital you borrowed. For example, if your $100k house appreciated in value by 5% in a single year it would be worth $105k. If the loan on that house cost you $6k in interest that year, then the loss to your net worth is $1k.

    Now that’s assuming that the house continued to appreciate, and you still lost money on your investment. If the house depreciates, then the financial situation is very painful because not only have you lost value in the home (you still owe what you borrowed), you’ve also still lost the interest you’ve paid on your loan. Whereas, if you were renting you would be able to negotiate for lower rent or you’d be able to move into another similar location where the cost of renting has mirrored the drop in the market.

    I realize that the tax break would help, but I doubt it would overcome the costs of maintenance, insurance, and property taxes.

    Renting definitely has huge benefits. As a member of the military, I’ve rented rooms for significantly less than the cost of a mortgage, and I have the benefit of flexibility when it comes time to move or deploy. I can’t imagine the hassle of maintaining a house from overseas, dealing with troublesome tenants, or being forced to live with 2 mortgages at once.

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