Tuesday, April 13, 2010

When to use Leverage

The effect of leverage is to amplify gains (or losses). You need be aware of leverage, respect it, and use it properly in order to build wealth.

Every other well off rich guy got there by borrowing as much money as possible, starting a company, then have the company borrow as much as possible.

Leverage is an essential part of wealth building especially in the early stages where you need outsized gains and can afford the risk. You have less on the line. You can fall down, get up and walk again with much less consequences than later in life.

The news keeps saying how banks were leveraged at 30 to 1, and how insane it is. However consider this. When you buy a rental property with a conservative 20% down payment, you are leveraging 5 to 1. Put 5% down and you are already at 20 to 1 leverage. Is that risky? Yes. But there is nothing wrong with it, especially when whatever you are leveraging has decent interest coverage, i.e. produces enough income to cover interest and more.

In fact leverage is one of the most attractive features of real-estate. A rental property that yields 6%, financed with 3% debt and 20% downpayment, gives an 18% yield. If it wasn't for leverage why would you go through all the trouble? You could go buy some discount perpetual preferreds that yield 6% and be done with it.

What to leverage

What is being leveraged is also an important factor. If that rental property is legal, insured, fire retrofit, has AAA tenants and produces a decent interest coverage, and the interest rate on your loan is somewhat fixed. Then you should leverage as much as possible. If you can even pull off 100%+ leverage good for you go for it.

On the other hand, if what you are buying is a single family home converted into a low income rooming house, the fire department and the city are calling you all the time about zoning and fire safety issues, half the tenants are on welfare and the place is falling appart. even though you could be generating a thoeretical 12% yield. do not even think about leveraging something like that.

I used real-estate here as an example, this also applies to stocks, its is dangerous to leverage a technology stock trading at 40x+ PE, however it is perfectly fine in my books to leverage a utility or pdf1 preferred stock or other high investment grade instruments.

When you use leverage you are adding risk, interest rate risk, amplifying gains/losses. You need to balance this out by using a safer investment.

The other factor to consider is your own risk tollerence. If you are getting ready for retirement part of your portfolio should be in cash equivalents, forget about leverage. If you are still in your early 20's then you should probably not leverage either because of your lack of experience in whatever you are investing in. add leverage as you gain experience. so probably in your mid 20's until you start having those little dependants we call kids. then its time to adjust your risk tollerance.

The banks who were leveraged at 30 to 1 thought their investments were AAA rated; meaning the risk to their principal involved was close to nil. Even though they were wrong. The lesson is only leverage safer investments.

4 comments:

  1. Great post. This point is often missed.

    ReplyDelete
  2. Wanna write a guest post for the moneygardener to promote your blog?

    ReplyDelete
  3. MG thanks for your comments,
    yeah I'd be glad to write a guest post, I'll get back to you when i have a good one.

    ReplyDelete
  4. The very heart of your writing shilst sounding agreeable at first, did not settle very well with me personally after some time. Someplace within the paragraphs you were able to make me a believer but just for a while. I nevertheless have a problem with your leaps in assumptions and one would do well to fill in those breaks. In the event you actually can accomplish that, I will definitely end up being fascinated.
    Its such as you learn my thoughts! You seem to grasp so much approximately this, such as you wrote the ebook in it or something. I think that you simply can do with some% to force the massage house a bit, however other than that this is magnificent blog. An excellent read. I will certainly be back.
    Property leveraging

    ReplyDelete