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Debt can destroy more than your finances. It can ruin your whole life, I said in the last newsletter. In this edition we will look at the other side of the coin: how debt can be applied positively to phenomenally increase the return on your investment.
Before I explain the process, I must remind you to plan money matters carefully before taking any action. Remember: the higher the reward, the higher the risk.
Using debt to increase wealth is known as leverage. It works like this: you borrow money to purchase an asset that you expect to increase in value. Then you find someone else to pay back the loan. Suppose you buy a flat that is worth R800 000. You could pay cash for the flat and earn a rental income while waiting patiently for inflation to increase the value of your investment. Or, you could borrow the money and let the flat, using the rent to pay back the bond. If you pay cash, the rate of return is calculated on the full amount, R800 000. Should you pay a deposit of R80 000, but take a loan for the rest, the return is calculated on the R80 000 investment. At the end of the investment term the value of the flat will be the same in both examples, but the return will be much bigger in the second case where you invested a smaller amount. That is because the smaller investment needs to grow at a higher rate to reach the same final amount.At a property inflation rate of 10% the value of the flat will
be R5,38 million after 20 years. During this period the value of the investment will therefore have increased almost six fold (572%). Should you make a deposit of R80 000 and the bond is paid off after 20 years, the value of the investment will be the same as when one paid cash. However, the rate of return is now calculated on the amount of R80 000 and not the purchase sum of R800 000. This result in a much higher rate of return – in this case the return has increased to 5 660%, thanks to leverage! Before you invest in property you should know enough about the subject to ensure that you pick up a bargain or at least purchase the property for a reasonable price. A rule of thumb is to check if the property could be let for more
than 1% of its value. A property worth R800 000 should fetch at least R8 000 per
month.
There are also other aspects to think of:
· The area in which the property is situated should not lower its value. Property prices rise in good areas over time, but that is not the case everywhere.
· Your cash flow should be able to absorb increases in the interest rate.
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Borrowing money and using leverage has increased the rate of return from 31,2% to 122,47%! But once more, keep in mind that risk increases with the rate of return. Should the butchery fail to make a profit the investor will be in trouble. Therefore you should do your home work properly before attempting transactions such as these.
Businesses can also use leverage to their advantage. Suppose an investor buys a butchery for R700 000 and its net profit per month is R38 000. He pays a deposit of 20% and borrows the rest of the purchase price at 10% per year for 15 years. To illustrate the advantages of leverage in relation to a cash buy, let’s look at the following:
| |
Buy butchery cash |
Pay a deposit of 20% |
|
Own capital
Debt |
R700 000
R0 |
R140 000
R560 000 |
| Total |
R700 000 |
R700 000 |
| Gearing factor |
0% |
80% |
|
Operational income
(4% on asset before tax)
Minus debt payment @10% interest |
R28 000
R0 |
R28 000
R6 018 |
| Net jearly income before tax |
R336 000 |
R263 784 |
| Net jearly income before tax of 35% |
R218 400 |
R171 460 |
| Return on own capital |
31.2% |
122.47% |
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Borrowing money and using leverage has increased the rate of return from 31,2% to 122,47%! But once more, keep in mind that risk increases with the rate of return. Should the butchery fail to make a profit the investor will be in trouble. Therefore you should do your home work properly before attempting transactions such as these.
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PLAN YOUR WEALTH
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