One of the many arguments surrounding real estate investment, whether as a true financial investment, or as a lifestyle investment for personal residence, involves using "other people's money" to finance the purchase. That is, use leverage through mortgages and secured lines of credit to provide the necessary financing. This is often touted as a benefit of real estate investing -- lever up and a small investment of $20,000 turns into $200,000. Fancy terms are thrown around by financiers showing double-digit returns on initial capital invested. Wow. But don't sign me up just yet.
Let's look at a simple case of me with a business idea. I want to open a store selling popcorn. I think have a decent business case but, unfortunately, no money with which to carry out my fancy plans. I need to find some capital through investors. One place I can go is the bank which has boatloads of money. I can also see if some of my business contacts are willing to pony up the dough for my venture.
The thing is, when I use "other people's money" they have a funny way of wanting a cut of the returns for use of their money. The bank manager sees me and looks at my business case, offering me a loan at 10% annual interest. My business partners are willing to invest but want an equity share of the business. Some even offered to fund it and have me work as an employee. No matter how I slice it, I have to give up some of my potential returns in exchange for the use of capital.
Now we can turn to real estate and housing. When my family walks into a bank interested in applying for a mortgage, there is little difference between this and my popcorn investment. Sure popcorn is a bit more risky than housing, but for the bank, which has access to a fixed amount of capital, both are considered pretty much equally, adjusted for risk. The bank needs to maximise its returns and manage risk.
It may not seem like it, but when the mortgage specialist fills out the online form including your income, assets, liabilities, credit history, et cetera, she/he is but filling out a streamlined business plan on our behalf. We can sometimes lose sight of this with the big rosy smile on the broker's face and McMenus of financing options.
Mortgages are, in their essence, nothing more than business ventures. The most important thing to realise is that, like most business ventures, you are passing on some of the profits to the initial holders of the capital. Unless you are speculating and benefit from unsustainable capital appreciation, your returns will, on average, be less with borrowed money than they would should you have your own money to invest instead. There is nothing absolutely wrong with this -- one may forgo future savings for present day benefit and borrowing capital is often necessary for a venture to happen at all; both are usually the case with owner-occupied real estate purchases.
Using "other people's money" is not free, especially if other potential non-real estate investments are producing decent returns, such as in the late '90s. I asked a few people why they didn't invest in properties ten years ago that were netting 7-8%. The answer: there were lots of other investments doing better with a lot less overhead. In fact, mortgage rates of the day were over 7%, reflecting how competitive other businesses were for available capital. It seems the trough of money is not bottomless after all, especially when business is booming.
Disagree? Do you think you can always do better with borrowed money? Let's hear it.
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