The Power of Leverage - Property vs Shares

What makes for a better investment? Property or Shares? This debate has been has been going since I can remember, and there are proponents on either side of the fence. In this short, 1 min article, I will explain to you why I think investing in property beats investing in shares.

To understand why property is a better investment, we first need to understand the concept of leverage. If you are new to the world of finance or property investment, this is definitely a term you need to know. When you want to buy a house, most people use a little bit of their money and the rest comes from the bank. For example, if you want to buy $400,000 house, and you have a $50,000 deposit, then you need to borrow the remaining $350,000 from the bank. Now, the bank doesn’t own this money, it comes from people like you and me depositing our money with the bank. So, in essence, you buy this $400,000 house by using only $50,000 of your own money and $350,000 of other peoples’ money.

In contrast, if you wanted to buy a share, you can’t borrow other peoples’ money to buy it. So, if you wanted to buy $400,000 worth of shares, and have only $50,000, the bank will not give you the remaining the $350,000.

Herein lies the biggest difference between property and shares: if you want to buy a property, you only need to use a little bit of your money and a lot of other peoples’ money. By using other peoples’ money (i.e. borrowing from a bank) you are able to gain access to the property and entitlement to any movements in the value of the property. This is what is known as leverage. You can leverage property, but you can’t leverage shares.

So, what’s the point, you may be asking?

Lets look at two investors, Johnny and Joe. They both have $50,000 just sitting in the bank. Johnny decides to invest in property and Joe decides to invest in shares. For this example, we will assume both property and shares grow in value by 10% p.a.

1 - Johnny uses his $50,000 to buy a $400,000 property. He borrows $350,000 from the bank. In 10 years, his property is now worth $1,037,497. His property has grown in value by a whopping $637,497.

2 - Joe uses his $50,000 to invest in shares. In 10 years’ time, his shares are now worth $129,687. That’s an increase of $79,687.

Who has come out on top? They both had the same amount to invest, but because Johnny was able to leverage his property and borrow against it, he was able to purchase an asset valued at $400,000. Joe, on the other than, had to use all of this $50,000 to buy $50,000 worth of shares.

The main point is that borrowing enables you to buy a more expensive asset (the property at $400,000 vs the $50,000 in shares). Because the property is more valuable, the 10% p.a. growth compounds on this greater amount. The 10% p.a. growth when applied to shares, only compounds on the amount of shares you buy (in Joe’s case, he bought $50,000 in shares).

The power of leverage should not be underestaimted and, when understood can help crystalise and guide your investment decisions.