Ways Investors can use Leverage

I am no expert on investing in rental properties. I can mange them and look after them, but there are people who know far more than me when it comes to investing. I came across this article for a couple of months back that i thought was interesting and you could benefit from.

Pete Wargent wrote this article for propertyupdate.com.au 

As someone interested in property investment you would already understand how leverage magnifies your investment returns.

However, let’s look into this a little more closely firstly for real estate investment and then how you could use leverage as a share investor… Suppose you have the choice of acquiring one of two assets, providing returns as follows:

Asset A (property)	Asset A (property)	Asset B (shares)	Asset B (shares)
Asset value	$100,000	Asset value	$100,000
Rental yield	4%	Dividend yield	5%
Capital growth	7%	Capital growth	9%

On the face of it, Asset B provides more growth and a stronger yield. But if you are able to use more leverage on Asset A, then the resultant returns may be stronger:

Asset A (property)	Asset A (property)	Asset B (shares)	Asset B (shares)
Leveraged asset value	$450,000	Asset value	$200,000
Rental yield	4%	Dividend yield	5%
Capital growth	7%	Capital growth	9%
Capital gain – year 1	$31,500	Capital gain – yr 1	$18,000
ROI from gain	31.5%	ROI from gain	18%

The rental income and dividends would also be higher, but the cash flow would be used to cover some of the costs of lending.

Leverage in property

Here are just four of the many ways you can use leverage in property:

1. Saving a deposit

You can save up a deposit of, say, 20% plus transaction costs (stamp duty, legal fees etc.) and invest in property using 80% leverage which is a big head start on equities.

2. Pyramiding

Property investors begin to move ahead by waiting for their early properties to appreciate in value and drawing out some equity to acquire further properties. Does this introduce some risk? Yes, there is always risk when using leverage.

However, look back the modern history of Australian residential property prices – is there any 25 year period where prices were lower at the end of the period than at the beginning?

No, and this is why mortgage lenders are happy to allow investors to borrow so heavily.

A typical residential property mortgage has:

·         Long loan term
·         Relatively low interest rate
·         High LVR

This unique triumvirate of conditions associated with the financing of residential property means that property investors have historically finished well ahead: even in countries where prices have tanked, those who have been in the market for the long-term have prospered handsomely.

3. Using a LOC and a buffer

Advanced property investors know how to borrow more than they need using a line of credit (LOC) which covers any cash-flow shortfall.

4. Trusted professional investor

Some advanced property investors are able to continue borrowing funds even if they are not employed full-time. If an investor has shown a proven track record of being able to manage cash-flow with a reasonable buffer, it’s possible even for moderate income earners to eventually employ huge leverage.

Investor Ian Hosking-Richards has a property portfolio of greater than $15 million in value, yet he never earned a salary of more than $50,000 per annum. Lenders see him as a worthy investor who has proven that he is able to handle his finances while pyramiding, and therefore he is able to continue using their funds.

Here are 6 of the many ways you can use leverage in equities:

1. Margin loans

The available leverage varies depending on lending sentiment, the state of the market and the type of stock. You may be able to achieve leverage on a blue chip stock of 50% LVR.

2. Pyramiding margin loans

Through using newly-acquired shares as collateral, it can be possible to ramp up leverage in equities. You may find a lender to extend you a loan of $100,000 fairly easily, depending on your income and available equity.

However, the lending party will reserve the right to issue margin calls if the loan-to-value ratio (LVR) falls too low. Thus you may be forced to sell some of your holdings at an inopportune moment due to the volatility and perceived level of risk in the share markets.

3. Derivatives

Derivatives are financial instruments which are derived from the value of an underlying security or asset…there are stacks of them! Futures, options, forwards, swaps…

Share investors may acquire put options as insurance against adverse portfolio movements, giving them the right, but not the obligation, to sell a parcel of shares at a certain price in the future.

Traders can also use options as a form of leverage. Through writing options investors can earn the premium paid by the option buyer. This is great if the option closes out of the money or expires without having been exercised. If it doesn’t, then the option writer must pay the difference between the market value and the exercise price, so you need to get it right.

Not for beginners.

4. CFDs

Trading CFDs allows market participants to go either long or short on equities using great leverage. I’ve known plenty of people to “do their stash” in precisely this manner. Obviously if you get it right the returns can be fast.

It’s interesting to note what the ATO (tax office) thinks of CFDs: unless you can show that you are a regular and experienced trader, finance charges may not be granted as a tax deduction. The tax office is classifying you as a gambler. That should probably tell you something.

5. Spread betting and “Spread betting shorts”

Back in the ‘Old Dart’, some UK trading websites promote the idea of “spread betting shorts”. Theoretically this is preferable to short-selling because the transaction is classified as a bet and therefore any winnings are not taxable.

I’ve more than a sneaking suspicion that speculators go down this path either because they don’t actually know how to sell short (or don’t have sufficient trades under their belt to find a broker who will allow them go short).

Let’s be frank, this isn’t really shorting. The clue is right there in the title: it’s betting.

6. Trusted professional investor

The only way you will be able to use massive leverage in equities is to become a trusted, professional investor. It can be done over time, but most average investors will never achieve this level.

Some hedge funds manage to use massive leverage, and not only to hit up equities. When Soros “broke the Bank of England” he shorted the British currency selling a massive $10 billion in pounds…when his fund’s assets were only $7 billion. And he had planned to sell closer to $15 billion! Now that is serious leverage!

The double-edged sword

Leverage is a double-edged sword. It magnifies both gains and losses, so it should only ever be used with great care. Most average investors will never be able to use great leverage in equities, but through learning the appropriate skills they may be able to do so in residential investment property.

This article was first reported on propertyupdate.com.au January 24, 2013