THE POWER OF LEVERAGE IN PROPERTY INVESTMENT
It took Daniel Young four years to get over his fear of debt. Lucky he did, otherwise he would not have achieved a net worth of $10 million and a property portfolio that exceeds 70.
Like many young Australians, Daniel was taught by his parents that debt was bad. By thinking outside the square, however, Daniel was able to discover that despite its risky nature, debt also carried immense potential – the power of leverage – that could maximise gains and bring the savvy investor to financial freedom much quicker than anticipated.
Through understanding the ways in which leverage works and looking at its benefits and mitigating its risks, the investor can learn how to use debt in a smart and responsible way in order to magnify gains and prevent devastation.
GOOD DEBT VERSUS BAD DEBT
As a consumer, if you were given the choice between taking on good debt rather than bad debt, which debt would you choose? Most people would choose good debt – no question about it. But is this really what we are doing in our daily lives?
Daniel Young says, “Good debt generates an income and should be an asset that goes up in time, whereas, bad debt doesn’t generate an income and doesn’t have a good chance at going up over time.” An investment property with a strong yield and upside for growth, that has been purchased on borrowed money (at an affordable rate on reasonable terms) carries good debt.
In contrast, a car that has been purchased on finance carries bad debt because, not only is it likely to depreciate in value, it will not make you any money either. In fact, it will cost you money instead. Credit card debt is also another example of bad debt. It offers no income, no asset and is charged at a high-interest rate. This makes it a bad debt and a liability, not an asset.
What about your family home? Although it carries growth potential, it doesn’t generate cash-flow – making its debt a mixed bag of good and bad.
Think of all of the people you know. As consumers, do they take on predominantly good debt or bad? Unfortunately, a huge proportion of Australians stunt their financial growth by getting into bad debt. This feeds the common perception that debt should be avoided – blinding us from the benefits that good debt has to offer in the form of leverage.
WHAT IS LEVERAGE?
Put simply, financial leverage involves using borrowed money to invest. It enables the investor to put more money into purchasing an asset or assets than they otherwise would have been able to – thus, creating the potential for increased gains.
For example, let’s say you inherited $250,000. You could use this money to purchase one apartment outright and reap the strong cash-flow (albeit subject to tax) that an unencumbered investment would subsequently bring. On the other hand, you could use it as a deposit on five different apartments. Assuming the properties were bought in a good location with upside for growth and had neutral to positive cash-flow, these five properties would ideally look after themselves in terms of cash flow while also increasing in value in the medium to long term.
Your capital gains would be five times more than if you had purchased the one property, allowing you to earn greater equity and increase your net worth position. In this scenario, borrowing money in order to ‘leverage’ your own has thus magnified your gains.
BENEFITS OF FINANCIAL LEVERAGING
In addition to increasing the amount you can invest, leveraging provides “time value,” says Daniel. “If it takes a first home-buyer six to seven years to save for a deposit, imagine how long it would take them to save for the whole thing,” he says. By borrowing money, “You’ll be able to get into a property much sooner than if you were to save for the whole thing.” In fact, says Daniel, if you were to spend your whole lifetime saving to buy a property, its value would probably increase beyond what you could save anyway – making it unattainable.
“Most people wouldn’t be able to save and then invest $1 million in their lifetime with after-tax dollars, whereas people could be able to go and borrow $1 million in a couple of weeks” he says.
THE RISKS OF FINANCIAL LEVERAGING
Imagine you had used the same strategy described in the best-case scenario above but had executed it poorly. Say, for example, you borrowed money in order to purchase five properties in a high-risk area, such as a mining town. If the properties dropped in value and you could no longer get a sustainable amount of rent to cover your loan and other monthly expenses – then let’s face it, you would be absolutely screwed. You would have negative equity on five properties and you would be paying off these investments (de-vestments?), in large part, from your own pocket.
Net worth? Forget it. Selling all to consolidate would result in a capital loss that would be five times greater than if you had over purchased on one property with your own money. And did I mention that after selling your properties you would still be in debt?
ASIC’s MoneySmart Website lists four common risks involved with leveraging that could affect your ability to pay off debt:
1) INVESTMENT INCOME RISK
When the expected income from an investment is lower than anticipated. Daniel says, sometimes damage awaiting insurance can cause a prolonged vacancy and loss of rent. Market conditions, such as oversupply, can also have a negative impact on investment income, making it more difficult to find tenants willing to pay market rent. Other costs, such as unexpected repairs or Strata Levies, can also turn a positive cash-flow negative. “You’ve got be able to ride out the times when cash-flow is bad,” he says. To be able to do this, it is important to have an adequate buffer in place.
2) INTEREST RATE RISK
When rates rise, upping the cost of loan repayments. When financing a property it is wise to use a higher interest rate (such as the historical average which sits at 7 – 8%) in affordability and yield calculations. That way you can remain reasonably protected from the risk of interest rate hikes. Yes your property may return more, but you still bought it knowing that it can still pay for itself should conditions change.
3) INCOME RISK
When the loss of income due to injury, redundancy, etc. affects whether you can service your loan. Again, having a buffer or income protection policy can be the difference between retaining your investment and being forced to sell.
4) CAPITAL RISK
When the capital value of an investment falls below what it will cost to pay off the loan. This creates negative equity. According to Daniel, this occurs when investors over pay for a property and can be devastating in the case of a market crash. It is important not to overcapitalise, he says. Don’t let your emotions tempt you into paying more than the property is worth – and don’t buy a high-risk investment.
BE SMART WITH LEVERAGE AND MINIMISE RISK
In order to get the most out of your debt, you should be extremely diligent in reducing risk and maximising your investment. Daniel says investors should do the following:
1) Have an adequate buffer in place – about three month’s worth of rent – to protect against unexpected costs.
2) Buy below market value to protect against the possibility of having negative equity.
3) Buy in Metro areas where demand for renters is higher and property prices are more likely to retain their value.
4) Buy properties that have a good upside for growth.
5) Don’t buy high-risk investments, such as properties in mining towns or properties that are sold off the plan.
6) Buy properties that offer a strong yield so that they are paying themselves off. Don’t buy something that is heavily negatively geared or produces a big negative cash-flow.
7) Have an exit strategy. If you had to sell suddenly, would you get your money back? Would you be able to cover exit costs and estate agent’s fees while selling for less than the property is worth?
8) Don’t bite off more than you can chew and don’t make decisions based on emotions.
9) Respect the fact that you are using other people’s money to invest and you need to be doubly careful when doing so.
In summary, the idea of leverage is nothing new. The earliest recorded mention of a mechanical lever which could make a very heavy load relatively light and reduce the physical effort required to lift it was penned by Archimedes in the 300 BCE. While it is true a poorly made or calibrated lever can break, a soundly constructed one consistently increases the efficiency and potential of the user. When considering financial leverage you need to make sure it is strategically planned and expertly constructed.