August 04, 2014
Yew Kong Lye
In my last article I explored the concept of the magic compounding. When that is combined with an understanding of the power of leverage, they can be very powerful tools for successful investing.
This is especially true in property investments due to the liberal lending policies of investment home loans offered by banks.
We will now explore how leveraging can significantly increase your asset base and when combined with compounding, will dramatically increase your wealth with time. Hang on to the levearged investment and give it enough time, it will grow to proportion unrecognisable from from the first investment.
The Concept of Financial Leverage
Financial leverage simply means the proportion of the secured asset that is funded by a bank loan. For example, if you're using $100,000 of your savings and borrowing $100,000 from the bank to invest in a portfolio of shares worth $200,000, you have a leveraged portfolio of 50%.
Similarly, if you borrowed nothing and invested the $100,000 of your savings, you're not financially leveraged.
The Positive Impact Of Financial Leverage
Consider the example above. If share value rises by 10%, the unleveraged portfolio will yield $10,000 in profit while the leveraged will yield $20,000. If you have to pay 5% in interest to borrow the $100,000, you’re still $5,000 better off when your portfolio is leveraged with a total return of $15,000 after paying the interest.
Now imagine you leveraged an investment property with a loan of $900,000 and together with your $100,000 you bought an investment property and kept it for 30 years. Ignoring other cost and assuming that the property increases by 10% every year, your investment property will be worth $17,449,400 after 30 years.
If you decided not to borrow and remain unleveraged and spent your $100,000 on a very modest investment property, it will be worth $1,744,940 after 30 years (assuming a growth of 10% is achievable). Not a bad outcome and you would have made more than $1.6m. However, had you decided to leverage, you would have made a profit in excess of $16m, in both situation starting with the same capital of $100,000. That’s the power of leverage.
The Downside of Financial Leverage
Where there’s an upside, there’s always a downside, just like the Yin and Yang of life. The down side of financial leverage is that, when the invested assets are falling in values instead of rising or interest rates are much higher than your returns. That can really get you into serious trouble.
Imagine you invested the $200,000 in 50% leveraged situation in shares and it falls by 10% in value from what you have bought them at. Your share portfolio will now be worth only $180,000, not to mention that the interest to service the loan will be at the whatever interest rate that the moment.
In this situation, you’re in all sorts of strive and will certainly be subject to a margin call. This occurs when your share value falls to a value calculated by the bank's particular formula.
Harness the Power
It is then very obvious that to harness the power of leverage, you should be careful to invest in an asset class that has a good history of appreciating and that you’re not forced to sell and subject to margin calls when the asset is falling in value.
In my opinion, investment property satisfies these criteria especially if it’s well located and held for the long term. It has a good track record as an investment vehicle and offers the best opportunity to leverage. Not to mention, a favour asset class for investment with banks.
“When you combine ignorance and leverage, you get some pretty interesting results.” - Warren Buffett. Call 0413 871 888 NOW to find out how you can leverage your home equity to invest in property safely.