Leverage in property investments?

Property is one asset class where it is possibly easiest to purchase an asset for a far higher price than what you actually have in a deposit or in a cash payment to the other party. It is of course possible to do it in other asset classes as well, you can purchases shares on the Stock Exchange via margin, but in property transactions the approach is fairly well known. The principle revolves around using the Banks money to help fund the purchase. The question to be asked though is what are the pros and cons of purchasing an investment property through using other people’s money or the bank’s money as part (or even all of) the purchase price.

As an example - let’s say you purchased a property for R500 000, and financed it via a deposit of R50 000 (10%) and used a loan from a bank for the balance of the purchase price of R450 000. If after transfer in your first year of ownership, the value of the property went up by 10% as an example, you property would be worth R550 000. Your pure capital return of R50 000 when divided into your investment of R50 000, has given you a return on your investment in year one of 100%. Very impressive right? In the above example I have kept it relatively simple by not including transfer costs in the calculation, but those of course have to be taken into account. The numbers can be experimented with using a bigger and even smaller deposit to see the corresponding effect on the return on investment calculations. The power of leverage can very clearly be seen from this simplistic example.

Of course however there are downside risks that have to be taken into account. The first one being leverage can work the other way as well. As an example if the price of the property went down by 10% in year one, you would still owe the bank close to R450 000 and your investment in the property therefore would have been “lost”, if you needed to sell the property in that scenario. Basically this is a complete reversal of the paragraph above.

The key to this for me lies in the cash flow calculations and your ability to manage risk and possibly greed in these scenarios. In Robert Kiyosaki’s Rich Dad Poor Dad Books, he very clearly says that any property that is generating a positive cash flow from month one should be bought. I believe a lot of investors make the mistake in the beginning of having to “feed” their investment too much in the initial years and thereby make themselves susceptible to interest rate increases, and downturns in the economy more than those that follow Kiyosaki’s basic principle. The cash flow generated from the property is simply , the net rental or, the gross rental less your monthly Landlord overheads (rates, levies, bond repayments, repairs and maintenance , vacancy provisions, letting fees). In terms of managing the risk, if in the early years of an investment the property is financed conservatively (a larger deposit) and an investor doesn’t over commit himself by buying too many marginal investment properties, leverage can be a very powerful tool in building wealth. Ensuring that the investment property is an area where rentals should be escalating by at least inflation every year and in an area where capital growth prospects are good are also key determinants in your investment choice. Vacancies are huge negatives for any Landlord and ensuring your property is going to be relatively easily let is very important as well.

I believe the focus for investors should be cash flow and to see the capital growth as the gravy on the property. None of us really can predict capital growth with any degree of confidence, but if your investment is cash generative from day one, you can sleep easier knowing that when the capital growth comes, you will benefit. Leverage under those circumstances can be your best friend, but as always manage risk, don’t be greedy , and be in a position to not have to sell the property in the early years if the market falls .