Enhanced Returns Through Judicious Leverage
Let me start by first saying that leverage involves the use of debt, which can be quite dangerous. In the text we discuss how ridiculous it is to carry a balance with a credit card company, paying them upwards of 15% or 20%, thus allowing the incredible math of compound interest to work against us instead of for us. So why am I now suggesting the use of debt within our investment pursuits?
The answer lies once again in the simple math of it all. If for example, you contemplate the idea of purchasing a $1,000,000 investment property that has the potential to appreciate at the rate of 5% per year, you might not be too excited about the prospect. Why take the risk and deal with the illiquidity associated with real estate for such a small yield—only 5%? Well, if you finance a portion of the purchase rather than paying cash for the property, the investment return changes quite significantly. Suppose you deploy only $250,000 of your own cash and borrow the other $750,000 from the bank in order to complete the purchase. Rather than only a 5% yield on your investment, your return might be significantly better. Here’s the math:
$1,000,000 purchase price Grows to:
$1,250,000 (5 years @ 5%)
– $750,000 (paying off bank after 5 years)
$500,000 (net proceeds)
Result: $250,000 grows to $500,000—a 100% profit!
So instead of generating only a 25% profit over 5 years or 5% per year (simple), you end up with a 100% profit or 20% per year (simple). A significant improvement due to leverage. You can still deploy your full $1 million by purchasing a $4 million property using the same formula, or as an alternative you can purchase four $1 million properties and also benefit from diversification.
Now, once again for the sake of brevity, I have used an over-simplified example and have not yet discussed any of the challenges or the full risk exposure. So let’s touch on a few of these. First, you probably noticed that the loan was “interestonly” because the full $750,000 was due when the property sold. The question is: what about that interest—doesn’t that subtract from the total investment return? The answer is yes—unless you invest in income property whereby the tenant pays rent sufficient to fully service the loan along with the other expenses of property ownership. Ideally, you as the investor should expect a positive cash flow during the ownership period and should also enjoy all the benefit of the leveraged capital appreciation. Otherwise, the investment should probably be avoided.
Simple versus Compound Interest
Notice also the use of a simple interest calculation in the above example. This was done to keep the math simple and make the basic concept easy to understand. But this might be a good time to discuss the difference between simple and compound interest for purposes of calculating investment yield.
Chapter Three: Investing For Financial Independence |91
We’ve discussed the concept of earning compound interest on your savings and investments and the fact that earning interest on interest can produce very large gains over time. If, however, you earned interest only on the original principal invested, then it would be a simple interest return, and a higher rate of return would be required under that scenario to produce the same results. Following are the simple and compound returns on the above investment examples:
Annual Yields
All Cash
$1,000,000 (5 years) —>$1,250,000 = $250,000 growth
Simple interest: 5%
Compound interest: 4.56%
Leveraged
$250,000 (5 years) —>$500,000 = $250,000 growth
Simple interest: 20%
Compound interest: 14.87%
As you can see, to produce the All Cash results above it only takes a 4.56% compound return, while to produce the Leveraged results only takes a 14.87% compound return. To put it another way, if you place $1,000,000 into a savings account that pays an annual compound return of 4.56%, you would end up with an account balance of $1,250,000 at the end of five years. And depositing $250,000 into an account paying a 14.87% annual compound return would produce a $500,000 balance in the same time-period. For the sake of comparison, most investment returns are quoted in compound terms, also referred to as Internal Rate of Return (IRR).
There are many other considerations and challenges involved with real estate investments, especially when they are leveraged. For example, what if the value of the property goes down instead of up? A 5% annual reduction in value would wipe out your $250,000 equity entirely if you sold after 5 years. Or what if your tenants move out and you are unable to make the mortgage payments to the bank? Or what if there is a balloon payment and you are unable to secure new financing? The bank will foreclose on the property and take it away from you, resulting in a total loss of your investment. And what if you personally guaranteed the loan? Now the bank can come after your other assets, putting everything you own at risk. Bad idea, don’t ever do that.
Because of the above risks, many astute real estate investors work toward having all of their real estate completely free and clear, and any debt that they do have encumbering the real estate is to be non-recourse so they do not become “a servant to the lender.” (Prov. 22:7). It is also crucial that you have substantial cash reserves so that you can weather the many unexpected challenges along the way.
What about property management responsibilities? Do you have the time for that, or will the rental income be sufficient to pay for professional property management? Suffice it to say, there is much to consider when making a real estate property investment, and you should seek wise counsel before attempting to make your first purchase.
Hopefully, I haven’t frightened you away from the idea of leveraged investing with all of these challenges and considerations. Our family has experienced many favorable investment results over the years, but some of our greatest investment returns have been via tangible investments. We have carefully selected and negotiated a number of real estate investment opportunities over the years, and with the judicious use of leverage, our investment returns have enabled us to execute on Formula 15 and achieve financial independence at a relatively early age.
Oh, and by the way—be very wary about buying into a real estate investment with negative cash flow. You need positive cash flow, with significant potential for expansion of that cash flow, in order to have any expectation of appreciation in market value for future sale purposes. And finally, don’t get taken in by the threat that a particular investment opportunity won’t last. There’s another opportunity every day. Make sure that the purchase deal you make is truly a hot bargain; otherwise, wait till the next one comes along.