One
of the quickest ways to acquire a portfolio of properties is to
use the power of leveraging. By borrowing funds to purchase a property,
one can effectively magnify its capital growth, gaining sufficient
equity more swiftly to allow you to borrow further and repeat the
process as many times as you like until you have a property portfolio
This is a commonly touted investment strategy and the mathematics
behind it show clearly why it works.
You
can see from Graph 1 that as the percentage borrowed increases (ie
as the leveraging increases), the return on the property investment
is magnified enormously. Clearly, the more you can borrow in this
situation, the more rapidly your investment will grow. The more
rapidly it grows, the more quickly you can acquire the next property.
There
are a couple of limiters to this situation, however. Firstly, there
is a limit to how much banks will allow you to borrow. Generally
speaking, they are not going to lend you the high percentages that
allow you to achieve massively magnified returns. But there's a
reason why the banks are so unhelpful in this area and it's to do
with the underlying assumption used to generate the graph.
The
graph that shows the dramatic magnification of returns is predicated
on the assumption that the return on the investment (ie capital
growth plus rental yield) is 1.25 times the interest rate (ie if
interest rates are 8%, then the total return is 10%). Changing this
ratio changes the detail of the graph. As long as this ratio stays
above one, the shape will stay more or less the same, with only
the rate of increase altering. But what happens when the ratio dips
below one? That is, what happens when the total return is less than
the interest rate? You get Graph 2.
Graph
2 shows the flip side to large scale leveraging. When the total
returns are poor, leveraging exacerbates the situation. What was
positive growth, now becomes a loss-making investment. And, as with
Graph 1, the higher the percentage borrowed, the more dramatic the
magnification. There's one more case to consider and that is the
case where the total return is negative. The impact of leveraging
a negative total return can be seen in Graph 3. At first glance,
Graph 3 may seem like a heady return to the halcyon days of Graph
1. Alas, no. While the multiplier is positive, the original return
was negative, so we're magnifying a negative number, which means
we're making larger losses than we would have without the leveraging.
The banks know all about graphs 2 and 3 and this is the reason why
they limit the percentage that they allow you to borrow. They're
not too keen on you making large losses - partially because they
care deeply about your well-being, but mostly because if you lose
too much money, eventually you start losing their money also. And
if they do let you borrow a large percentage, you can bet that they've
passed the risk onto a mortgage insurer.
But
how often do the situations shown in Graphs 2 and 3 come up? How
often is the leveraging going to make things worse? Examining the
Sydney housing data since 1980, we find that total returns were
less than interest rates in 6 years (ie 30% of the time). However,
at no point in the last twenty years were total returns from Sydney
houses negative. Assuming these trends were to continue into the
future then, for any given year, there is a 3 in 10 chance that
leveraging will worsen your return and a 7 in 10 chance that it
will improve it. A 7 in 10 chance is good, but not great.
How
can one make it better?
Firstly, select your investments wisely. You need a property with
strong capital growth prospects. Rent alone will generally not ensure
that you are outpacing interest rates. Invest in areas likely to
grow well, and invest in properties in those areas that have something
special about them.
Also
remember that house and land packages almost always show better
returns than units. Once you find a property with good capital growth
prospects, make sure that you pay the right price for it. If you
pay 10% too much for a property then that's 10% less overall return
you are going to make. You can't rely on the person to whom you
eventually sell it to also pay 10% too much. Do careful research
on the property before you buy and ensure you pay no more than market
value for it. Having invested in a property with strong capital
growth prospects and at the right price, you should hold the property
as long as possible. You may be unlucky and have one or two bad
years. Maybe even three. But over the long term, the odds will even
out and the total returns from your investment should be such that
the leveraging works for you.
A
corollary to this is to ensure that you can make your repayments,
even if interest rates rise. Remember that as you increase your
debt, the impact of a change in interest rates increases also. The
absolute last thing you need to happen is to have interest rates
increase, and be in a position where you can't meet your repayment
obligations and therefore have to sell your property in a market
that may have few buyers. An obvious solution here is to fix your
interest rates for as long as possible. Of course, fixing interest
rates involves a trade-off in flexibility as most lenders penalise
borrowers who pay out fixed interest rate loans early. So if you
need to get out of the loan before you end the fixed term for whatever
reason, this will end up as an expense.
Fixing
interest rates for a long period of time diminishes your future
options, but fixing them for a short period of time doesn't completely
solve the problem of being at risk from interest rates fluctuations.
Ideally, you will keep interest rates fixed long enough to ensure
that the capital growth in your property has increased its value
to the point where even if you have to sell in a high interest rate
environment, you don't suffer a loss. How long this is will be a
judgement call, but one should probably err on the side of a longer
fixed interest rate term than a shorter one.
These
guidelines may seem self-evident, but the more you leverage the
more important they become. Graph 1 shows that leveraging your property
investments can significantly magnify the returns on them. But keep
in mind graphs 2 and 3. It also correspondingly magnifies the risk.
Housing is a low-risk investment, not a no-risk investment, so if
you are going to magnify the risk by leveraging, you should offset
that increased risk as much as possible by following the guidelines
in this article. Few of us are wealthy enough to treat property
investment as a gamble, and none of us can guarantee against a run
of bad luck with our investments. What we can and should try and
do is ensure that we can survive the bad luck, and later reap the
profits of improving fortunes.
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© Australian Property Investor magazine. Reprinted with permission.
