Crunch This: The Miracle of Leverage

Dear Pat,
We’ve been saving the past several years for a down payment, but now that we’re finally ready to buy, the stock market appears ready to take off again. We missed the wild stock upswing a few years ago, and I’d hate to tie up our money in the wrong place now. What do you think? We are…
-Crunching the Numbers

Dear Numbers,
The silence you’re sensing is the sound of me trying to politely stifle my guffaws, for while I’m happy to see the stock market moving again--especially for the folks whose retirement portfolios were devastated three years ago--the market simply never could compete with home ownership as an investment. Now, if that statement sounds brash to you consider the parable of the Players and the Smarts as I’ve outlined in painfully numbered detail below.

But first, let's take a look at the three major stock indexes over the last ten years. The Dow rose about 266% during the period, while the Nasdaq rose a similar 268%, and the broader S&P 500 gained 238%. So let’s use a 250% average of these averages, and assume that $10,000 invested in XYZ wholemarket fund in 1994 would be worth about $25,000 today.

And that’s exactly what the Players (Jim and Wanda) did: they ponied up their ten grand to buy the wholemarket fund in 1994, watched it peak at $36,000 in 2000, and ease back to $25,000 today. They continue to rent the same apartment, which has risen from $600 to $950 per month. Meanwhile, John and Mary Smart, the Player’s neighbors across the hall, bought a nice two bedroom bungalow in Longfellow that same year for $73,248--the average price of a home in our neighborhood back then. Down payment and closing costs totaled $10,000. The Smarts monthly payment, including principal, interest, taxes and insurance, has averaged $582 over the last ten years. And in this time the value of the Smarts home has risen to the Longfellow average of $181,400--an increase of 248%. Thus, the value of local real estate has grown about two-and-a-half-fold over the period, virtually the same as the stock market.

So what’s the big deal, you say? Well, crunch this, Numbers: the Player’s cash investment has grown from $10,000 to $25,000, while the Smarts cash investment has grown from $10,000 to $124,772 (their current net equity)--a whopping 1248% increase! What’s responsible? The principle of leverage, where a down payment (in this case, 10 percent) allows a buyer to control the entire asset as it grows in value. I’ve simplified the Smart’s example to illustrate my point--you may further crunch the numbers by subtracting their costs of repair and sale, but it barely affects the outcome. Real estate is without question the highest-yielding, safest investment you can make. Play the market if you like, but please--buy the house first!