I’ve discussed the first component of wealth building, Time Value of Money, in another post. In this post I am discussing the second component Leverage, the pros and the cons. First some definitions and I’ll have examples.
Leverage is the use of borrowed funds to finance an investment. A Positive leverage is when an unleveraged investment has higher returns than the cost of borrowed funds. The investor would be in a position to finance more investments increasing his/her yields on the investment portfolio. With higher leverage therefore higher yields the risk on investments also increases. Risk is the uncertainty associated with an investment. The higher the risk, one would expect higher returns. Some factors include Liquidity, Marketability (supply & demand), Time Value of Money, Quality (asset condition), and Quantity. Negative leverage is the opposite, and, a break-even situation is natural leverage.
The components of leverage are:
a) Loan to Value Ratio (LTV)
b) Interest rate
c) the term
- An investment may not be possible without financing. It is often the case in real estate investments.
- Finance a higher value investment with borrowed funds than all-cash
- Spread the risk, i.e. finance more or finance in various investments
- Increase yield
- Decrease in interest rates increases the value (and vice versa)
- Increase in interest rates would impact performance and potentially impact the ability to service debt (make the payments)
- Increase in interest rates decreases the value (and vice versa)
- Less cash flow due to servicing debt (higher yields thought)
Example 1, unleveraged & financed investments
An investor pays $70,000.00 all-cash for a townhouse with after tax net income of $10,200 a year. The yield for his all-cash investment is 14.5%. This is the rate of return (ROR) on the unleveraged investment. See definition above.
Now if he borrows 70%, i.e. 70%LTV, at 5% annual interest rate (which possible as of this post) what would be his rate of return? He has invested $21,000 of his money, and borrowed $49,000 @5%.
Net Return = Unleveraged Return – Cost of borrowed funds
Net Return = (70,000 X 14.6%) – (49,000 X5%) = $7,750.
ROR = 7,750 / 21,000 = 37%
Example 2, effect of more leverage
What if he finances 80%? What would be his ROR?
Net Return = (70,000X14.5) – (56,000X5%) =$7,400.
ROR = 7,400 / 14,000 = 52.8%
Example 3, Let’s add 3% inflation to example 1.
All Cash: inflation 2,100+ cash flow 10,200 = 12,300 . Return on equity = 12,300/70,000=17.5%
LTV 70%: Inflation 2,100 + cash flow 7,750 = 9,850. Return on equity = 9,850/21,000 = 47%
The POINT: 3% inflation gain translates to 10% gain when financed.
LTV 80%: inflation 2,100 + cash flow 7,400 = 9,500. Return on equity = 9,500/14,000 = 67.8%
The POINT: 3% inflation translates to even higher gains of 15% when 80% financed (see example 2).
Caution: The power if leverage has equal NEGATIVE impact in a deflationary situation. In equity market that will result in margin calls.
How Much Can You Buy When 100% Financed?