JUNO INVESTING ©

THE IMPACT OF LEVERAGING

JUNO INVESTING ©
THE IMPACT OF LEVERAGING

 

The editorial below reflects the views of the editorial contributor only and content may be out of date. This article is sourced from a previous JUNO issue. JUNO’s content comes from sources that it considers accurate, but we do not guarantee that the content is accurate. Charts are visually indicative only. JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions.

WINTER 2015

By Jack Powell, Investment Adviser, Private Wealth Advisers

More often than not, investors need to borrow money from the bank to finance a large part of a property investment. This form of borrowing, also known as leveraging, can work to your advantage when investing in rental property.

One thing that can be said about New Zealanders is that we have a love for property that is unrivalled throughout the developed world. This is mainly due to the belief that property is as ‘safe as houses’, which according to Hotten’s slang dictionary is a saying that was first recorded in 1859 and thought to have come about when the railway bubble began to burst and investors started to again favour housing.

Over the last 22 years, property prices in New Zealand have produced attractive real returns (after inflation) with Auckland leading the way with 5 per cent real per annum; this is well ahead of the rest of New Zealand, which produced 2.3 per cent real per annum over the same period. More recently though, growth in some main centres such as Auckland and Christchurch has produced double-digit real returns, while the rest of New Zealand has gone backwards. (Figure 1.)

In Auckland the rental income that is being produced by property has not kept pace with rapidly rising house prices, and has led to investors receiving yields of only 3-4 per cent of the property price per annum. This being the case, why is property investment seen as such an amazing investment in New Zealand? One of the more likely reasons, that is often overlooked or misunderstood, is the impact that ‘leveraging’ has on the investor’s return.

Leveraging, when used prudently, can enhance investment returns when investing in property and other income-producing investments, but can equally increase volatility, and the chances of loss, when used in excess. In brief, leveraging is when you use the bank’s money (a mortgage) to pay for the majority of the purchase price of a rental property. So the bank has paid the majority of the house price, but you the purchaser receive all of the capital gain, with the small deposit and interest costs on the loan being the only investment you make.

As a very basic example, let’s assume you buy a $500,000 rental property that increases by 10 per cent over a year ($50,000 capital gain). You only put in 10 per cent of your cash as a deposit ($50,000), with the other 90 per cent being funded by the bank. The property produces $22,500 in gross rental income over the year. The bank charges you 6 per cent interest ($27,000) on the mortgage, which is interest only. If we ignore all the transaction costs, and tax advantages, and just work off these basic numbers your return looks something like this:

 

Your deposit:  $50,000      

Capital gain:  $50,000

(10 per cent of $500,000)

Rental received: $22,500

Interest costs: $27,000

Net gain:  $50,000 (capital gain) + $22,500 (rent)

– $27,000 (interest) = $45,500

 

So in this basic example you have made a net return of $45,500 on your $50,000 investment for a return of approximately 91 per cent in one year.

In my view this is the main reason people love investing in property in New Zealand, and the majority of them do not realise that it is the leveraging that has given them the large returns, not the ‘safe-as-houses’ capital growth.

This view is relevant to the leveraging discussion because you can also leverage into other investments such as shares, and any other income-producing assets. Few do this though, because shares are more liquid and hence more volatile, and have produced many more negative headlines than property – think the 1987 stock-market crash, or the 2000 tech bubble.

Factors to consider when leveraging are:

• Liquidity
How fast can you exit the investment?

• Expected future returns
Is the asset overpriced or underpriced?

• Interest rate expectations
Are bank mortgage rates high or low?

• Certainty of income
Rental income, dividends from shares and coupons from bonds

• Banking covenants
Loan-to-value ratios or required interest rate coverage

Managing the level of leveraging is vital, with a need to minimise the risk of total capital loss through lower, sensible levels of leveraging, while still holding some leveraging within your investment portfolio. There is no universally accepted level of smart leveraging, and as such it can vary from zero to 90 per cent, depending on your risk profile. 

To reduce risk in leveraged portfolios you should also consider diversifying your investments across not just different properties, but also shares and bonds, or other investments. Increasing diversification reduces the risk of loss if any one asset class does fall in value. By borrowing against existing investment properties to invest into other asset classes, investors can very easily transfer some of the capital value, thereby reducing their large property exposure, and tactically diversify away some of the risk inherent in potentially overpriced properties.

A word of caution to all those that are already borrowing as much as they can to invest into the property market: As shown in Figure 1, property prices can, and do, go backwards in New Zealand. If you are borrowing, or leveraging to invest, and house prices decline, then the loss is also leveraged, and you can lose your capital very quickly and potentially end up bankrupt. 

In conclusion, leveraging is very much the way of the modern world, with governments and corporations leading the way with large levels of debt. For individual larger investors leveraging can be tactically built into investment portfolios to make the portfolios better diversified and more tax effective. Leveraging with no diversification is adding a large level of risk to property owners’ portfolios, and while it has produced excellent returns for the majority of property investors to date, it also increases the risk of large capital losses if the property sector in Auckland, or other major centres, was to ever suffer a decline. Consider diversifying some of this risk away.

 

DEFINITIONS

Bonds: a bond is an investment where an investor loans money to (typically) a government, which borrows the funds for a period of time at a fixed interest rate.

Capital gain: when an investor sells an asset at a higher price than they paid for it.

Inflation: the rate at which the general level of prices for consumer goods and services is rising.

Leveraging: to use debt to finance an activity. For example, borrowing money in the form of a mortgage to buy a house. Leveraging is an investment technique in which you use a small amount of your own money to make an investment of much larger value.

Net return: the income from an investment after deducting all expenses.

Real return: the actual payback on an investment after removing the effect of inflation.

Volatility: how much and how quickly the value of an investment, market, or market sector changes.

Yield: the income one receives from an investment.