Leverage how to wield the double-edged sword without getting hurt.
The Greek mathematician and Scientist Archimedes famous for establishing the theory of physical leverage, probably never applied his theory to finance. If he had mastered the theory of financial leverage, he might have been known today as a financial genius rather than a mathematician.
Leverage can make a task easier, however if the leverage is applied incorrectly, its easy to get injured when the stored energy gets displaced.
In the world of finance, leverage can enhance your returns if used properly, however most investors dont use or calculate leverage properly. Most investors use it blindly without knowing that they are increasing the risk of the stored energy being released on them just like a mouse flirting with the cheese in a trap.
To properly apply financial leverage you must know several things;
- What is the return on the investment you are considering?
- What is the cost of the leverage?
- Does the leverage increase, decrease, or have no effect on the return?
- How long is the investment timeframe?
If you have not calculated all the numbers, you have no idea if leverage is helping you or hurting you. A case in point, most of the real estate investors that got caught in the downturn were using leverage inappropriately it caused many of them to lose everything (the unwinding of financial leverage). The scenario below illustrates and investment and how leverage can effect it.
Assume you have the chance to invest in a Magic ATM machine that pays you $1,000 per month in perpetuity. The monthly payment is after all costs to operate insure, and maintain the ATM machine are paid, and it never has to be replaced.
You can purchase this ATM machine for $120,000. You realize the opportunity and decide to purchase the ATM machine, but you do not have $120,000 you only have $24,000 in your bank account. Your contact your local bank, and ask for a loan, they respond with the following options:
Loan Amount | Down Payment | Interest Rate | Term | |
Option 1 | $108,000 | $12,000 | 7% | 10 years |
Option 2 | $96,000 | $24,000 | 3% | 7 years |
Option 3 | $120,000 | 0 | 8% | 15 years |
Option 4 | $108,000 | $12,000 | 9% | 30 years |
Which option would you choose? They all are within your down payment range, and they all allow for the purchase of the ATM machine.
The answer is, we do not know which loan is most advantageous, we need to compare the CAP rate to the loan constant on each of the loan options. The cap rate is calculated by taking the income after all expenses excluding the loan payment and dividing it by the purchase price of the investment. In our case, that is $12,000/$120,000 for a cap rate of 10. The loan constant can be used to compare the true cost of borrowing. The loan constant is calculated on a fixed rate loan by adding the annual debt service (P&I) and dividing by the loan amount.
Once you have calculated the cap rate and the loan constants, simply compare all the loan constants to the cap rate and the loan with the lowest loan constant is going to have the least amount of risk, and provide the most cash flow.
There are three types of leverage, Positive, Neutral, and Negative. Positive leverage can be defined as the return on the increases with financing. Neutral leverage is defined as the cap rate and the loan constant being equal, not positive or negative. Negative leverage can be defined as the return on the investment decreases with financing. To generate positive cash flow, the loan constant must be lower than the cap rate. Most people look at the interest rate of the loan and assume that if the interest rate is lower than the return from the investment it is a good deal, in reality the interest rate is irrelevant. By calculating the loan constant, you can determine if the leverage will help or hurt the investment. The loan constant for each of the loan options are;
Loan Constant | Leverage | Cash on Cash Return | |
Option 1 | 13.93% | Negative | -25.40% |
Option 2 | 15.68% | Negative | -9.21% |
Option 3 | 11.47% | Negative | -0 |
Option 4 | 9.66% | Positive | 13.10% |
Positive cash flow does not equal positive leverage
Only one loan actually enhances our return that is option 4, which takes our original 10% return and increases it to a 13.10% annualized return. Notice that is also has the highest interest rate; most people would typically choose the lowest interest rate without making these calculations thinking the lowest rate is the best. If the leverage is negative, you will have negative cash flow and add additional unnecessary risk to the investment.
In addition to cash flow, leverage also affects Equity buildup, taxes, and appreciation. In relation to taxes, interest paid is usually a deduction, the use of leverage creates this deduction. With leverage, you use less dollars on each investment, however the appreciation is still realized over 100% of the investments value even further expanding the return or gain. As your loan is paid down over time, your equity will increase in value. Leverage applied properly can boost returns in many areas, and. Applied improperly applied can have the opposite effect.
Many real estate investors financed properties with negative leverage prior to the crash in 2008-2009, they got the equivalent of a financial spring loaded and set mouse trap uncoiling squarely on their shoulders (de-leveraging) and the cheese was left for the next mouse to come along and take safely from the mouse trap using proper leverage. Use leverage intelligently to increase your investment returns but make sure to run the calculations. If you do, you will be investing like the top 1% of all investors.