Interesting facts about leverage

Leverage is essential and without it, Investors will struggle to get their ROI's to impressive or even respectable levels. This example illustrates the benefits of leverage:

If someone offered you a 10% annual return on your cash investment, would you be interested or suspicious?

What about 30% or even a 500% annual return on your cash investment, would you be interested or suspicious?

The truth is most of us would’ve stopped listening at the 30% mark, let alone numbers like 500% or more, but maybe we shouldn’t be too hasty as this example shows?...

I buy a house for $500K and earn $50K/year on rent. My return for cash invested is therefore $50,000/500K = 10%

I buy the same house for $500K, but this time I use $250K cash and borrow $250K. I still earn $50K/year on rent, pay the bank back *$17,000/year leaving me $33,400 therefore my return for cash invested is $33,400/250K = 13.0%

I buy the same house for $500K, but this time I use $10K cash and borrow $490K I still earn $50K/year on rent, pay the bank back *$33,400/year leaving me $16,600 therefore my return for cash invested is $16,600/10K = 166%

I buy the same house for $500K, but this time I use $1K cash and borrow $499K I still earn $50K/year on rent, pay the bank back *$34,000/year leaving me $16,000 therefore the return for my $1000 cash investment is $16,000/1K = 1600%

These examples illustrate a number of important points:

Firstly, if there is no limit to how much an Investor can borrow, there is also no limit to how much they can earn on their cash investment and also the returns follow an exponential curve as shown in the graph above. For example, we borrow nothing and earn 10%; we borrow 1/2 the money and earn only 13.0%; but when we borrow 98% or more, suddenly we are earning 150%+ on our actual cash investment, so the ROI % scales up very quickly towards the upper limits of borrowing.

Secondly, whilst a 1600% ROI is impressive, the Investor has only actually invested $1000 and still has $499K sitting in the bank and wouldn’t find it that easy to structure another 499 properties on the same basis as the first one.

Thirdly, the more an Investor can borrow they more they can make! In fact the only way to make the really big cash-flow ROI's (in property) is to borrow, but not so obvious from the example, is the risk of excessive borrowing for the sake of leverage. Investors should carefully note that in any situation where they can borrow 98% or more (as shown in the last example), it would only take a small increase in, for example interest rates, to make the investment cash-flow negative, with the added risk of devaluation of the property on an Investment basis.

For Investors’ reference: financial advisors usually consider leveraging, with LTV ratios in the order of 50-60%, to be relatively safe.