What does Leverage mean in Real Estate Investments? In this article, I will try to highlight the two most important concepts which make Real Estate investments stand out: Leverage and Capital Gains Exemption.
Home ownership is often referred to as opening up a mandatory saving bank account, with every mortgage payment you are having your equity increased in the property. Furthermore, the asset is an appreciating one in the long run and that factor adds to the value proposition.
Aside from being an appreciating asset, a resting place which we call as our home brings the quality of life, stability, and joy to the family and a nest to grow memories.
By Leverage here is meant that with a small amount of money at 5%-20% as down payment you can buy a home worth much higher by leveraging the lending institutions money i.e. using the borrowing capital and utilizing its growth for your gains. When you sell the property down the years, the value appreciation in the home is for the entire property value and is yours to keep and not just the growth of your portion of the initial investment (down payment). This is classic concept of Leverage.
Let’s consider an example to understand better, suppose Joe and Jill buy a home for $450,000 by putting $45,000 (10%) as down payment and it rises in value by 3% after a year, so its a gain of $13,500. Going by this the return on their initial down payment investment is 30% (13,500/45,000 * 100), if you reduce the other costs involved in closing costs/interests payments, still the growth outweighs the expenses. Further, we should add to this growth the principal component paid off with every mortgage payment which increased their equity in the home.
On the other hand, if Joe and Jill would have continued to stay in rental and instead bought a bond or a GIC with a 4% return on their initial investment of $45,000. It would have given them a return of $1,800. And no addition to their personal equity as part of paying rent.
The second incentive of home ownership is the Capital Gains Exemption. Any increase in the value of your home or any other investment vehicle is termed as capital gain. Any gains in the mutual funds, stocks, bonds, GIC’s, they get added to your annual income and you pay taxes based on your tax bracket.
However, for a primary residence in Canada, any capital gains realized are exempted for tax purposes. This makes the homeownership much more appealing for first time home buyers. This benefit of 100% tax exemption is applicable only when you are selling your primary residence, this is not true for secondary property where 50% of the capital gain will become taxable.
There are cases when you are better off to stay on rent, and you can visit my blog -> Renting Vs Buying where I have tried to objectively compare rent vs buying for their advantages and disadvantages.
Wish you all the best.