If you’re thinking of investing in property than you need to become familiar with a concept called leverage. Leverage is the process of using a small amount of your own capital (say a $100,000 deposit) to invest in a large asset (say a $500,000 property). Leverage can amplify your returns because a small percentage increase on a large asset can give you a bigger gain than a higher percentage increase on a small asset.
Example of Leverage in Property Investing
Assume there are two investors, Daniel and Jenna, both of whom have saved $100,000 and are seeking to invest their money to achieve an annual return of 10%. Jenna decides to invest her $100,000 in an index fund, while Daniel decides to purchase a $500,000 property. What annual return would need to be achieved on the fund and the property for Jenna and Daniel to achieve their desired return on investment over a ten-year period?
Daniel has used leverage to increase the size of his asset base from $100,000 to $500,000. The result is that he needs his property to grow at only one-third of the rate (3.6% vs 10%) required for the investment in the fund to achieve his target return. In other words, a 3.6% per annum increase on a $500,000 property is equivalent to a 10% per annum increase on your investment ($100,000 deposit) after accounting for costs.
Unfortunately, we’re conditioned to believe that if a property doesn’t double in value every seven to ten years, it’s a poor investment. In reality, an annual return of 3.6% after costs still generates a higher return on investment than you’d likely achieve by investing in other assets, particularly when accounting (or adjusting) for risk. Daniel has, however, exposed himself to the risk that negative returns are also amplified because of leverage. To mitigate this risk, he invested in a property close to a stable demand centre
In the ten years to June 2017, combined capital city house prices increased by 73.8%, or 5.7% per annum. Had Daniel’s property kept up with the average, it’d be worth $869,000 and he would’ve achieved a return on his investment of 15.5% per year after costs!
While leverage can be powerful, it can also be risky. If you’d like to know how we can help you mitigate your risks, contact us today.