Why Is Financial Leverage Only Ok In Real Estate?

If you talk to the average person, they have no problem with the idea of taking out a mortgage on a house with 20% down.  Most people would even agree that a guy who buys multiple properties with 20% down and uses them to produce rental income is a pretty smart dude; however, if anyone borrows money to invest in the stock market, most people I talk to believe the person is crazy!  This makes no sense at all to me.  Anytime a person borrows money to invest in anything, it is commonly referred to as “financial leverage.”  So why is leverage ok in real estate investing, but not when you invest in equities?  After all, historically, equities have much higher rates of return.  When you actually stop to look at the raw financials behind these “commonly held truths” a mortgage with 20% down is actually using 400% leverage!  Yet if a person uses 30% leverage within the stock market they are seen as a crazy risk-taker, often akin to someone pulling a lever repeatedly in a casino (with borrowed money).  I don’t understand this way of thinking at all.  Right now there are several dividend-payers out there (including real estate investment trusts) that will give you great returns on your investment dollars, and with low borrowing rates, I don’t see why this strategy is looked down upon so heavily.

Everyone Knows Stocks Are Way More Risky Than Real Estate

The defence of the “common sense” viewpoint is that stocks are much more risky than real estate, and that when you buy property you have a physical asset behind your dollars.  I think this is just an emotional misperception.  Because you can feel the walls of a house it gives the feeling of having more intrinsic value than a number on a line of your discount brokerage account.  That type of thinking is what led to so many people in the USA going “underwater” with their current mortgages.  People honestly believed that real estate would never see any major corrections.  The conventional belief was that a market could soften or stagnate for a few years, but you would rarely ever lose a substantial amount of money.  This “fact” was obviously flipped on its head the last few years as many homes in several different regions have lost 10%-60% of their value.  With reference to volatility and risk in the stock market, I always respond that the risk is really only relevant when you discuss time frames and a lack of diversity.  For myself, as a young investor with a 30-60 year time frame on my investments, I don’t see where people think the risk is.  Sure, in any given year I could lose 40% of the value of my portfolio, but if I don’t need that money, the idea that the world economy is going to quit growing for 20+ years is ridiculous.  I will say that if you’re “trading on the margin” there is definitely the danger of a margin call, but if you’re merely tapping your home equity to some extent, or borrowing to invest in your RRSP, there should be no fear of using leverage to your advantage over a long-term time horizon.

Financial Leverage – My Smith Manoeuvre Begins

When I tell many people about my plans to soon begin the Smith Manoeuvre they all say the same thing, “You mean you’re gambling your house on the stock market?!!!”  I will soon do a post about the specifics of the Smith Manoeuvre, but the gist of it, is that you borrow money using a home equity line of credit (HELOC), and invest it in equities.  The interest paid on any investment loan in Canada is tax-deductible, and usually HELOCs are available at the prime interest rate minus .5-.8%.  There is a lot to talk about in regards to the SM, but what gets me is people saying, “You can take out a loan for that much money to invest in the stock market.  That’s definitely using too much financial leverage.”  There is absolutely no extra leverage there at all!  The original leverage came in the form of the initial mortgage, this is just applying that same leverage in a much more beneficial manner (both in terms of return on investment and tax efficiency).

I understand that after the now infamous “lost decade” in the American stock market people are skittish about stocks, but if you look at the rolling 20-year averages, and at the world of stocks outside of the TSX 60 and the S&P 500, I don’t see where the real danger is.  Anyone up for “gambling their house” and using their financial leverage with me?

36
Leave a Reply

19 Comment threads
17 Thread replies
0 Followers
 
Most reacted comment
Hottest comment thread
20 Comment authors
  Subscribe  
newest oldest most voted
Notify of

I think the average person is just not comfortable with this type of risk. They sell when markets are down, which becomes a bit more complex when using the SM. You also need enough equity built up in your home to make it worthwhile. If you only have 30% of your $300k house paid off, you’ll qualify for a HELOC of about $30k. To me, that’s not enough money…I think you’d want to invest at least $50k and have a $30k buffer in your HELOC. That’s just me, though. I would only consider this strategy if my home was nearly… Read more »

There is nothing wrong with using your logic provided you can handle the volatility and don’t get into a situation with margin calls on stocks. That is when people get into trouble. A diversified portfolio paying a decent yield should cover the carrying cost on the HELOC and grow over time. The question is whether or not it is that much more than saving every month instead of making a payment.

hmmm. I don’t know – sounds too risky for me. ;) I must be one of those you are writing against. haha. I want to stay out of debt as much as possible. I would hate to risk put my house on the line (if I owned a house) no matter how confident I was.

I don’t see a problem with the Smith if you’re down for it, but I personally don’t have the stomach for it. I also value financial independence more highly than absolute net worth, so I’m fine with slightly less consumption in exchange for less variance. I have enough on my plate without wanting to worry about that.

If it makes sense for you though I’d love to hear more. I may change my mind in 5-10 years if my situation is significantly different … who can predict!

Although I’m happily renting and will be for a long time, I don’t think I’d feel comfortable borrowing money on my house to invest in the stock market.

Assuming I didn’t pay cash for my primary residence, it’d be a levered asset. I wouldn’t call it a levered investment. To me, your primary residence is not an investment unless it’s producing income. Unlike equities, the purpose of the home I live in isn’t necessarily to generate income. So, we’re not really comparing apples to apples. Now, when it comes to rental properties, I can see how your argument makes sense.

Borrowing money for x and loaning it out (in the form of investing in assets) at x plus y is a no-brainer. If you want to juice up your ROI, investment debt is a necessary evil.
This post shows how return accelerates when you use leverage for real estate investing.
Here’s where you might get squeezed:
-Margin calls. This can be solved by keeping a portion of your money in cash or cash-like equivalents
-Reduction in value of the real estate asset. Getting a long-term mortgage, preferably at a fixed rate, should offset any repercussions from a loss in value.

Good luck!

The answer is that houses only go up in value, whereas stock don’t. :)

Great post – I’ve noticed this as well. Buying a house with 5% down is ok, but borrow $5k for stocks? That’s insane (apparently.

Teacher Man, regardless of whether your in the business or not, your strategy and viewpoint is sound…you haven’t even given some of the best parts, like some investments could be SEG fund, which are partially guaranteed, and solid divididend or income funds. People are afraid of “equities” because the media tells them to be…a solid balanced investment is not as roller coastery as people think. Margin call loans are a factor, but there are many loan opportunities which you can find where you will not be subjected to this. Also, I may have missed this, but the fact that you… Read more »

Gerard

Seems to me your comparison is only looking at asset value, though. If I don’t make a leveraged investment in my primary residence, I’m still paying out that money in rent (i.e., leverage gets me “into the game” of using my monthly housing payouts to build up equity, even if my house doesn’t increase in value). And if I ever buy a rental property, the rent I can charge doesn’t go down 50% even if the appraised value of the house does. I know, dividends play the same role as rent checks do, but it seems to me that the… Read more »

Disco Fever

I see it firsthand with the would be ‘condo kings’ rental property investors that I work with. People tend to confuse the ‘familiar’ with ‘safe’ and they perceive ‘real’ assets (as in real estate) as being inherently safe because it’s tangible.

Asking them to do a ROI or FV calculation and show me how their investment condo is such a great deal is a lost cause.

If you can handle the leverage and don’t go crazy with wild speculations, you’re OK.

Lose your job and you’ll be living under a bridge. Leverage has been the problem in all of our financial crises. Banks tried to do what you’re doing and had to be bailed out. Buy triple A rated debt with borrowed money along with credit default swaps so they were insured How could that not work? “The best laid plans of mice and ….”
Good luck…I’ll follow your journey.

El-D

Let me suggest that you consider the experience of Japan. Plot the past 20 years of the Nikkei and ask yourself how foolproof this plan is:

http://finance.yahoo.com/echarts?s=%5EN225+Interactive#symbol=%5En225;range=19891101,20111101;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=;

El-D

“there is no chance that the whole world could see 0 growth at the same time” I agree; there’s always a bull market somewhere. If you are good enough at stock-picking (or index-picking) that you can survive the costs and drawdowns of 4:1 leverage, then you should probably be doing this professionally rather than with your HELOC! “…this couldn’t happen on a world scale over a 20 year period.” OK, 20 years? Who knows? (That’s kind of the point.) But there is at least one modern event in which it basically did happen globally, and it persisted on the order… Read more »

El-D

Are you thinking about this in real terms or in nominal terms? There are lots of 20-year periods for which both the DJIA and S&P500 were flat in real terms. When including both inflation and dividends, it’s still not a no-brainer!

Broadly speaking, there were three periods since 1900 that produced flat returns over 20-year horizons… take a look at this:

http://www.multpl.com/s-p-500-dividend/

Again, I’m not saying that this strategy can’t work; I’m just pointing out that some of the underlying assumptions might need more thought.

Tim

The difference between using leverage against your house and against you stock portfolio is the terms under which a margin call happens. Many people leveraged in houses and although the houses are way underwater the banks are not able to make a margin call on these homes. The terms of the mortgage allow you to continue to pay your mortgage even if you are underwater. In the event the same event occurred within a brokerage account they will have a forced liquidation of your securities to meet the margin requirements. If your timeframe is 10 to 20 years but a… Read more »

I would like to comment about the real estate business whether its buying and selling homes fixing them up what have you. I do not have anything against real estate investing. But lets be clear this is a business just like if I own a used car lot a health food store a convenient store any variety of businesses. Each type of business has its own little little quirks of sorts real estate is no different. To many folks look upon real estate as an investment and that is why they fail to succeed in the real estate business’ when… Read more »

Jeff

I don’t really get why people keep mentioning margin call. (Maybe the same reason why people think this is risky.) When you are using SM, you are borrowing against your home and using the proceeds to buy stocks. Unless you are using extra leverage when you purchase your stock, there is no possibility of a margin call.

Jay

Sorry I’m a noob to this and I don’t quite get it, If you are taking out that HELOC to then buy shares, How are you then paying back the HELOC, isn’t that recruiting interest daily?

Hi Jay,

With the Smith Manoeuvre, the interest is normally “capitalized”, which means that the credit line pays its own interest.

Have the bank charge your chequing for the interest. Then transfer or write a cheque for the exact amount from your credit line to deposit back into your chequing account.

This way, your chequing is not affected and the investment credit line in essence pays its own interest.

Ed

Hi Jay,

Yes, your HELOC is accruing interest daily. If you have a readvanceable mortgage, you gain credit available with each mortgage payment. You can reborrow this extra credit to pay the interest on your HELOC.

This is called “capitalizing the interest” and means that you borrow on the HELOC to pay its own interest.

Ed

This would make it a much safer investment than someone who might soon need the equities investment for retirement.

Share This