When discussing property (or any appreciating asset for that matter) we generally consider two broad principles: Cash Flow and Growth. The basic premise is, if you can generate $100k cash flow from a $1mil asset base then a $2mil asset base should provide $200k in cash flow, hence the desire for asset growth. (see my previous post on ‘Overnight Millionaires’ for more detail on this relationship).
The question remains: how do we double our money as quickly as possible (without putting it all on red at the casino)? The answer: Leverage. The higher the leverage, the less of your own money is invested and more of other people’s money is working for you (*). Let’s pause here for a second and consider this statement again… Higher leverage means:
- Less time saving for a deposit
- Less of our own money at risk (although we ultimately become responsible for the asset anyway)
- Lower ‘Opportunity Cost’ which is extremely important for more sophisticated investors. i.e. Less of our own money is tied up in one asset which allows a more generous use of our remaining cash/equity, enabling greater diversification of risk and maybe some leftovers for fun (think sports cars, yachts, holidays etc.).
For example, if we have $100k to invest at a growth rate of 10% per year, we have two very different outcomes with and without leverage:
- Without leverage: We invest our full $100k and at the end of the first year our asset is now worth $110k so we’ve effectively made $10k. Smart investor
- With leverage: We invest our full $100k but we spread our investment over 4 assets by borrowing $75k from the bank in each case and by putting $25k of our own cash into each asset. At the end of the first year our assets are now worth $440k so we’ve effectively made $40k profit PLUS we’ve also diversified our risk over 4 assets. Wise investor
Which would you prefer. Invest $100k to make $10k or invest $100k to make $40k (**). And the absolute beauty of this principle is… insert drumroll… the bank takes none of the profit. It’s all yours! (As long as you pay the interest).
In fact, I think the bank is the best partner you’ll ever have. They put up 80% of the money and take NONE of the profit.
A word of caution: Bank’s and other lenders can also be nasty so you need to make sure of two things (listed below) which I will discuss in more detail in future posts:
- You need to be absolutely sure you can make the repayments
- You need to ensure you purchase an asset which will in-fact appreciate in value rather than depreciate. The latter can be a downwards spiral towards uncontrolled debt. Think maxed out credit card/s and then multiply this nightmare by 100.
In summary, provided we are clever when planting our trees (acquiring our assets), leverage allows us to plant more of them (acquire more assets), thus increasing our capacity for cash flow and capital movement.
Disclaimer to readers (because it’s better to be safe than sorry): Any reliance placed upon the information provided in this document, and the appropriateness of opinions, assumptions and qualifications used, is a matter for your own commercial judgement. No representation or warranty is made that any projections, forecasts, values, assumptions or estimates contained in this document can or will be achieved.
* If you’re not familiar with the concept of making money work for you then please do yourself the biggest favour and read ‘Rich Dad Poor Dad’ by Robert Kiyosaki or ‘The Richest Man in Babylon’ by George S. Clason. The latter is my favourite but both cover fundamental concepts of wealth creation and money management for those looking to escape the ‘rat race’. I consider both of them to be the ‘bibles’ of wealth creation. The concepts contained within are literally worth their weight in gold or more.
** For those wanting a slightly more technical approach: Even if we take our interest mortgage repayments into account, we still end up on top. Let’s assume an interest rate of 5% on $75k x 4 properties. This equates to $3,750 for each property or $15,000 in total for the year. So, even if we subtract the interest repayment from our profit of $40,000 we end up with $25,000 NET which is more than double what we would have made without leverage.