Financial leverage is basically the practice of using borrowed money to supplement equity (non-borrowed money). In the field of private property development and investment, this is often done at a ratio of between around 20%-50% equity, the remainder being borrowed in the form of a mortgage.
The term ‘gearing’ is closely related to this subject. Gearing is the particular ratio of debt to equity. The proportion of debt is expressed as a percentage of the equity. So if a property is geared at a ratio of 65%, this means that the amount of capital borrowed to purchase the property is 65% of the total investment. In the world of finance, if a particular company is geared at 65%, then it would be regarded as high risk. However, private property investors might have to borrow up to 3 times the equity level. This would not be regarded as risky in the same way as corporations, but you should always acknowledge the risk factor in any investment. The return on your investment is the payback for accepting this risk.
A certain amount of financial leverage is not only (for the majority of people) inevitable, but it is also desirable. This is because of 2 reasons:
1. It enables a speculator to increase his holding several times over. It makes more financial sense to place 25% of your total investment into each of 4 properties, rather than placing 100% of it into a single one. This enables investment diversification (which helps minimise risk) and maximises potential future returns.
2. Purchasing a property using 100% equity is the most expensive way to run a development or investment company. This is because tax is payable on a company’s NET profits. If the vast majority of your return is regarded on paper as profit then you must pay tax on it. Mortgage repayments are regarded as liabilities and will subsequently reduce tax liabilities.
Property is quite unique as an investment as it enables speculators to borrow higher levels against the property value. This is because it offers a tangible investment. Even if the property remains unoccupied or unsold for an extended period of time, the lender will always have (at the very least) the land value to guard against the loss of their capital. Even if the building upon the land is destroyed somehow, the land will always have some value. Most other investments do not offer this.
An example of why financial gearing increases returns is as follows:
An investor purchases a property at a price of £100,000. Equity is £35,000, and £65,000 is borrowed.
Investment capital £100,000
Less loan £65,000
Property owners equity £35,000
Rent for initial 5 years £8,000 per annum
Less loan interest £5,200 per annum
Net income to property owner £2,800 per annum
Return on Property Investor’s equity £2,800 ÷£35,000 = 8%
So the property investor achieves a return of 8% per year for the first 5 years. However it is in the subsequent years where the advantages of leverage become clearer.
Reviewed rent for next 5 year term £10,000 per annum
Less loan interest £5,200 per annum
Net income to property owner £4,800 per annum
Return on Property Investor’s equity £4,800÷£35,000 = 13.71%
Subsequent terms will reflect even greater returns in comparison to the level of equity placed into the investment. This investment would be a 65% gearing.
It is highly unlikely that an investment of only £35,000 could produce a return of 13.71% and more if invested in stocks. Prior to the recession, Hedge Fund Managers spoke of producing returns of up to 40% per annum. However, a minimum investment is required (far in excess of our example value of £35,000) and the investment risk would be regarded as far higher than that of property. Many hedge funds have gone out of business post recession, taking their invested capital with them. Remember though, property is a tangible investment and it is difficult to foresee a situation where it would ever be worthless.