I often hear real estate investors say that “millionaires are created through investing in real estate”.
I’m not going to dispute that claim. Many real estate investors have a high net worth.
Part of the reason many real estate investors are wealthy is that real estate is a solid investment. Despite all of the shortcomings I’ve highlighted, real estate can help build wealth both through the monthly rent collected and the long term increase in real estate prices.
However, the real reason real estate investors might have more wealth than the average stock market investor is because they use leverage.
Leverage means you used debt to invest. In the case of real estate, this often means getting a mortgage. Real estate investors might put down 20% of the purchase price of a property and borrow the other 80%.
Each year the mortgage balance declines and (hopefully) real estate prices increase. The difference between the value of a property and the outstanding mortgage balance is the equity in the property.
For every dollar increase in a property’s equity, the investor’s net worth increases by a dollar.
The same logic of leverage applies when investing in the stock market.
It happens to be the case that investors are much more comfortable using leverage to invest in real estate, compared to other asset classes like stocks.
Leverage increases an investor’s expected return but it also increases the amount of risk they take on.
Risk and expected returns go hand in hand. The more risk you take, the higher your expected return will be. The expected return is not a guaranteed return. Plenty of real estate investors have taken on too much leverage and lost their shirts as a result.
The takeaway for investors is that we should not fall in love with any particular asset class. A lot of people have a “passion” for real estate. Passion is an essential human quality and serves us well in many areas of our lives.
Passion has no place in your investment portfolio. When making financial decisions that impact you and your family’s financial future, it’s important to make dispassionate decisions. Use all available information and make a cold, calculated decision based on the numbers and your risk tolerance.