Leverage

Leverage is the reason this not-so-humble smashed avo enthusiast returned just shy of 200% last financial year yet still didn’t come anywhere close to the real dollar return made by any risk-averse property investor during any single boom year period. I invest with my own capital. Given I’m a lazy, instant gratification-seeking, instagram influencing (okay this part’s a lie, I don’t influence anyone) millennial, this isn’t much money. Our risk-averse property investor on the other hand invests using his/her own money, as well as the bank’s money.

Leverage simply means borrowing money for investment purposes. It’s a powerful tool which can amplify your returns and make you a very rich person, or it can bankrupt you. We touched on leverage in The good, the bad and the subprime when we talked about mortgages and increasing your exposure to your investments but it’s a complicated concept so I thought it would be good to work through an example.

Ali is in the market for an investment property. She’s a savvy investor with a long-term investment horizon in mind. She finds a new apartment in a bustling neighbourhood with a new train station and hospital on the way. Ali thinks all this infrastructure spending will increase the value of her investment in the long-term and so, armed with a 10% deposit, she runs off to a bank and pitches her idea to a lending specialist. The apartment costs $600,000 and Ali is looking to borrow $540,000. Thanks to her handsome salary, excellent credit score and the bank’s pre-GFC style lending standards, Ali’s loan is approved within minutes. Ali’s interest rate is 4%.

It turns out, Ali had done her due diligence, and her investment property had an ROI (see Accumulating assets) of 10% per annum for the period of her investment horizon. Let’s take a look at Ali’s dollar returns. In year 0, the property was worth $600,000. In year 1, her capital gain and rental yield on the property has returned $60,000. Of course, we now need to reduce her dollar return by the value of her interest payments. She borrowed $540,000. 4% of $540,000 is $21,600. Her real dollar return for year 1 is therefore $38,400. Had she not taken on any debt and leveraged her position or increased her exposure to the potential return on the investment property, but still managed to yield 10% elsewhere, her real dollar return would have been $6,000. Ali’s investment returns become especially impressive once you factor in the value of compound interest (see The time value of money).

The above is a highly simplified example designed to explain how leverage can help you amplify your returns. However, in the real world, there are far greater considerations and things can always move in the opposite direction. Ali has to consider changes in interest rates, her capacity to keep up the mortgage repayments, financial downturns, natural disasters, costs associated with property ownership such as local council rates etc. What if a gang of birkenstock-sporting millennials move into the neighbourhood and devalue her wholesome property with their plum wine, adorable doggos and generally cheerful demeanours?

There is one other leveraged financial product I’m going to teach you about, but just promise to be careful okay? A margin loan is another type of debt you take on to use to increase your exposure to your investments. What in the name of Warren Buffet does that mean? Well, if you had $10,000 to invest in a particular publicly listed company, and you thought the company’s share price was going to rise 10% in a year’s time, you might take out a margin loan of $20,000 to amplify what you earn by 3x. Your profit is $3,000 (being 10% of $30,000) instead of $1,000 (10% of your original $10,000). Obviously, this is debt you’re taking on to (hopefully) invest in something productive, something which will appreciate in value. But, if you’re wrong, you’re also suffering 3x the losses. It’s the same concept as taking on a mortgage to invest in property, but what you’re investing in (usually shares) is highly volatile and carries a much higher risk of falling in value.

The amplifying effect described above is why we say you’re ‘increasing your exposure.’ Keep in mind that as with all debt, you’re paying interest on the margin loan. The interest payable on a margin loan is tax deductible and as mentioned, the reason you’ve taken on the debt is so that you can invest in something which will hopefully appreciate in value. This is why a margin loan is classified as ‘good debt’. However, unless you’re absolutely sure you know what you’re doing, you’re at a significant risk of losing a lot of money, even more than your initial investment. Because of the risks associated with margin lending, the majority of investors might steer clear from margin loans. Elite equity analysts (super intelligent finance people who research potential buying (or shorting) opportunities to add to a fund’s portfolio of assets) often think about margin loans when investing. I promise I’m not being condescending here and I genuinely do have your best interests in mind – I certainly form part of the majority.

Always be responsible in deciding how much debt you take on. Just because you can shoot yourself in the foot with a nail gun, doesn’t mean you should. Especially if you’re rocking those gross excuses for sandals and you miss the sandal straps. By the same token, just because the bank says you can borrow an eye-watering amount of debt, doesn’t mean you should. You understand your financial situation, your lifestyle and your capacity to make repayments better than anyone, including the bank.