What is Leveraged Returns?
Leverage in simple term is the use of debt to finance the purchase of asset.
It is an investment strategy of using borrowed money to increase the potential return from an investment. Property investment is one of the popular instruments that uses leverage for better returns.
How Leveraging Works
If you were to purchase a property of value $1M using 20% downpayment, meaning you put in only 20% of the money down and borrows the rest of the 80%. If the property were to appreciate by 5%, you would have earn $50,000 on the property investment.
Taking into account on the 20% of downpayment you put down:
Amount earned : $50,000
Downpayment : $200,000
Returns : $50,000/ $200,000 = 25%
Compare this to if you were to fully paid the property,
Amount earned : $50,000
Downpayment : $1,000,000
Returns : $50,000/ $1,000,000 = 5%
The returns from using leverage is much higher in this case.
This is a simple way of looking at leverage returns. Of course in an actual property purchase with borrowing (or leverage), we will need to take into account the interest incurred on the loan. If the return on the total value invested in the property is much higher compared to the interest you pay on the borrowed amount, you can make good profit.
Now, let’s consider another scenario:
If you were to purchase 5 properties (using Leverage) with your $1,000,000 instead of just one at $1M.
If all the 5 properties were to appreciate by 5%, your returns will be $250,000, compared to one property at $1M, your returns will only be $50,000.
With more number of properties, your property investment can be more diversified. You can also diversify by buying into different countries, different towns, different types of properties etc.
Having five rental properties, if one is unoccupied, the four others can still generate income until you can rent out the remaining one. Having only one unrented property is riskier.
Dangers of Leverage
Leverage is a double edged sword. If the price of the property were to fall significantly, you may end up owing more money than what the house is actually worth. If in the event that you are unable to pay and resulting in the default on the mortgage instalments, you may lost a lot of money in the property investment.
Another danger is that if the interest paid on the property loan were to increase much more than the rental returns and captial appreciation, then the return from the propety can be drastically reduced or even be negative.
Conclusion
Leverage is generally a very good tool in property investment.
It will work out well if you use it carefully. The important key is to know exactly how much leverage you should take on before the leverage becomes too excessive and risky. To find out more about this and debt servicing ratio, you can refer to my article here about Debt Ratio.
Only buy what you can afford and do set aside some buffer for unforeseen circumstances. It is always advisable to do a proper property planning and assessment before going into any property investment.
If you currently own more than 1 property, it is always good to understand how you can protect your property inheritance for your future generation. Read more here.
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