You can leverage in property investment, what do you mean?

Q.
What do you mean by leverage in property investment?

A.
In Finance, leverage means:

"the ratio of a company's loan capital (debt) to the value of its common stock (equity)."

Leverage: using the equity generated by the rising value of an existing property to purchase a new one. This property then grows in value, allowing the investor to repeat the process and buy again.

How leverage works

Leverage is a simple concept. It’s borrowing to increase the potential return of an investment. Taking out a mortgage to buy a home is a form of leverage.

Leveraging the equity in an existing property – whether a home or an investment – depends on the value of that property growing while the size of the mortgage reduces or stays the same. For example:

• You buy a property for $400,000, putting down a 20 per cent deposit ($80,000) and borrowing the remaining 80 per cent ($320,000)

• Over time, the property increases in value by $100,000. The 80 per cent mortgage would now only be 64 per cent of the property value – or less if you’re paying off the principal as well as the interest.

• You refinance, increasing your mortgage up to 80 per cent of $500,000. You create a cash pool of $80,000, which can be used as a deposit to buy an investment property.

Property investor and mortgage broker Jane Slack-Smith of Investors Choice Mortgages highlights a number of benefits to this strategy.

“Using equity in this way minimises risk by keeping your cash in your pocket – you’re not using your cash reserves,” says Slack-Smith. “It also takes a long time to save cash – say, five years to save $100,000. In that time, property values are likely to increase faster than the interest on your savings.

“By using equity in an existing property, you can get into the market today and buy at today’s prices, benefiting from the coming years’ growth.”

So, "Leverage" using property investing is using mortgage - a form of debt, to secure value in a property. This value, which is likely to appreciate over time, would enable a debt to achieve a higher return.

There are two parts to this leverage. First the diminishing of the debt as money gets smaller due to inflation. Second the appreciation of the asset value in a property over time.

Diminishing of debt. The borrowed sum of say 400,000, upon repayment over 20 years would mean that the actual 400,000 in 20 years worth very much less than 400,000 today. This is inflation. Although there is interest portion of the debt, it is generally below 5% and such interest rate would just hardly cover inflation. This is very much seen in a piece of roti canai, costing RM0.50 in 1998 is now RM1.50 in 2017. So, you borrowed RM0.50 in 1998, and in 2017, it is still a borrowing of RM0.50+interests. Not, RM1.50+interest.

Appreciation of the asset value. Property has this advantage of scarcity. A plot of land which is remote, after 20 years would be less remote. This can be accelerated by population growth and urbanization. Labour cost and diminishing resources will create higher cost for future asset generation. Thus, the overall increase in property value will outstrip inflation. In this way, it will hedge against economic depression as property, especially land is always a scarcity.

Indeed, no business or stock would leverage the way investing in property is. The borrowing for business is very much confined to the estimate of assets available as collateral. For example, if you are doing a cargo forwarding business. Your assets are lorries. Given a scenario that you lorries are worth RM400,000. Probably by giving them as collateral to the bank, the bank can loan you RM400,000. The bank would never give you more than RM400,000. Over the years, the lorries will depreciate, and the value of the loan will also need to come down. This is not the case if you have a warehouse instead of the lorries. The collateral of warehouse to the bank will appreciate over the years, and your loan in fact can increase as the warehouse (an industrial land) appreciate over time.

Similarly, if you are now going to buy some 400,000 RM1 share in a company, you probably would not get to the maximum of RM400,000. The Net Asset Value Per Share is NAVPS = (assets - liabilities) / number of outstanding shares, and usually it is lower than the book value. So, the bank would not loan you the traded shares price (which is inflated with speculation). They will only loan you the NAV to its maximum. Hence, this amount will also decrease as the business meet with its liabilities, e.g. bad debts not recovered, etc. Repayment for loan to businesses would likely have higher interest rate than mortgage.

The nature of the business and investing into shares is clouded with uncertainties. With economic situations and policy changes, investing in stock and shares carries higher risks than assets like properties.

The leverage advantage of properties is an unique feature in its investment rather than a norm. To call it an unfair advantage, to the envy of others, is not an understatement. The only thing is, it is long term and comes with a huge burden of repayment. To some, it might be too slow an investment and not a overnight get rich quick scheme.

Ref:

Kevin Eddy in "Leveraging investment property equity", available at

https://www.domain.com.au/advice/leveraging-investment-property-equity/