The Power of Financial Leverage. Why do Investors Borrow Money?
Because they can make a lot more money. Here’s how it works.
December 7, 2007 –
The reason people find it hard to understand the concept of financial leverage is that it’s math, and math is sometimes counterintuitive. Let’s say that there is an income property which could be bought for $1million. Then let’s assume that the annual net income, after all expenses are paid, is $100 thousand. That’s 10% of your investment, or a ten percent return on your investment. Of course you need to have $1 million in cash to do the deal.
What if you could put down only $200 thousand and borrow $800 thousand at 8%? Would that be better or worse? Why would you want to borrow at 8% when you are getting only 10%? It seems like a lot of risk for the 2% differential. Here’s where the counterintuitive part comes in. The annual interest expense of $64,000 would decrease your annual net income to only $36,000. Through the magic of leverage, the return on your investment is enhanced. That’s because you only had to invest $200 thousand, not $1 million. The chart shows the difference.
|
Purchase |
Cash |
Amount |
Interest |
Net |
Rate of |
|
Price |
Invested |
Borrowed |
Rate |
Income |
Return |
|
$1,000,000 |
$1,000,000 |
$0 |
N/A |
$100,000 |
10% |
|
$1,000,000 |
$200,000 |
$800,000 |
8% |
$36,000 |
18% |
|
$1,000,000 |
$200,000 |
$800,000 |
7% |
$44,000 |
22% |
As you see, the rate of return increases when some of the purchase price is financed, as long as the interest rate is below the basic rate of return, in this case 10%. By either lowering the interest rate or increasing the percentage that is financed, the investor increases the return on investment.
Profit can also come from appreciation, the increase in the value of property over time. If the property is sold in the future, the return is also greater when leverage is used. Let’s say the same property sells five years later for $1.2 million dollars. The property appreciated by $200,000. The person who paid $1 million cash earns only 20% overall while the person investing only $200,000 doubles their money.
It gets even better. An investor with $1 million cash, using leverage, could buy five properties at $1 million each with a cash investment of $200,000 per property. Just think about it – $1 million controlling $5 million. Using the assumptions in the chart, that same $1 million could return $180,000 (5 times $36,000) per year. And if the properties are each sold in 5 years for $1.2 million, the investor gains another $1 million from the appreciation of the properties. What does the chart look like with five leveraged properties vs. one property bought with cash?
|
Cash |
Amount |
5Yr |
5Yr |
Total |
Cash |
|
Investment |
Borrowed |
Income |
Appreciation |
Gain |
Return |
|
$1,000,000 |
$0 |
$500,000 |
$200,000 |
$700,000 |
70% |
|
$1,000,000 |
$4,000,000@8% |
$180,000 |
$1,000,000 |
$1,180,000 |
118% |
|
$1,000,000 |
$4,000,000@7% |
$220,000 |
$1,000,000 |
$1,220,000 |
122% |
Is this a great country or what? But the investment coin has two sides, the risk side and the reward side. What does the risk side look like?
In the example, the investor planned for a $100,000 net income (before interest expense). If the net income turned out to be only $40,000, the profit would still be $60,000 if you bought with cash. But if he/she leveraged, borrowing $800,000 at 8%, the interest expense would be $64,000, resulting in the loss of $24,000 a year.
If the property is sold for $800,000 (a drop in value of $200,000), the cash investor has a 20% capital loss while the leveraged investor has lost their entire investment.
Those who manage the leverage game well over time are called real estate investors. Those who do not are called speculators.
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