Few people would consider debt an important part of building wealth. While it might seem like the antithesis of financial independence — get into debt to make money — debt, through the prudent use of leverage, is a vital tool.
In simple terms, leverage refers to using borrowed money (ie: debt) to make a large purchase. This strategy allows you to magnify the return on your investment.
The most common form of leverage is purchasing property. Using a small percentage of your own money (down payment), you can acquire an asset worth 80% to 95% more than the equity you put in. For those willing to take on more risk, this strategy can be employed again and again to acquire more expensive properties or to build a real estate portfolio. However, the use of leverage isn’t limited to the purchase of real estate.
Imagine you had $100 to invest. You borrowed another $1,500 from your bank at an interest rate of 4% per year and then invested the entire sum ($1,600) in an asset paying 8% per year. At the end of the year, your original investment would now be worth $1,728. After you pay the bank back ($1,500 plus $60 interest), your balance is $168 — a 68% return! If you had only invested $100 at 8%, your profit would be $8.
While the returns from leveraged investments sound amazing, be careful. Leverage can significantly increase losses too.
For example, what if the investment you were sure would grow by 8% only grew by 2%. At the end of the year, your earnings would be $32. After paying back the principal debt and the interest owed, you would have a net loss of $28 ($60 in interest – $32 in earnings).
How the High-Net-Worth Investors Use Leverage
High net worth (HNW) investors use leverage in a variety of ways, such as borrowing to build a business or to build an investment portfolio.
Some of the largest fortunes in the world have been built on the power of leverage. George Soros famously netted US1$ billion dollars in 1992 by leveraging $10 billion in a short sale betting against the English Pound.
In most cases, these investors will use leverage as a way to access credit, which allows them to accelerate investments and take advantage of short sell or market opportunities, such as undervalued U.S. properties or equities.
This is what Dave Nord did when he was a student at Western University a couple of decades ago. (We’ve changed his name to protect his privacy and the privacy of his family.) As a business student, Nord saw how many students chose to live off campus. He bought a rambling house near the campus where he lives while also renting out rooms to five other students. Between the money he made at a part-time job and the rent collected from his roommate friends, Nord doubled-up his mortgage payments every month and, after three years, he had a sizable portion of equity in the house. After graduation, Nord sold the house for a profit and purchased three older condominium units in sought-after locations in the Greater Toronto Area. Using a bit of grit and sweat, Nord renovated the condos and sold each of them for a profit. (He lived in the third, before selling that, too). With this seed money, Nord began to build his real estate business — buying buildings with multiple units, renovating and either selling or holding and managing the properties, using the rent collected to pay the mortgages.
Today, Nord owns six multi-residential properties in southern Ontario, where he is based, as well as properties in Florida and Hawaii. Almost all the buildings were purchased using a mortgage, despite the fact that his savings could easily pay off these outstanding debts. Nord continues to use leverage as he still sees value in using other people’s money to secure high-value, income-producing assets that he expects to grow in value. Through proper planning, Nord is in the process of significantly paying down the mortgage on two properties, so that the income earned in rent can be used as annual earnings in his retirement years.
“Most people will draw from a retirement fund, such as an RRSP, when they stop working,” says Nord. “I use the rent money collected from my investments to secure inflation-adjusted earnings.” He adds that this rental income — which currently gives Nord $60,000 per year — won’t deplete the value of the underlying asset, the rental property. For those doing the math, Nord’s inflation-adjusted annual earnings equate to a nest egg of $1.5-million. And that’s for just one property.
Looking back, Nord considers leverage as the key to his financial independence.
How You Can Use Leverage to Grow Your Nest Egg
Real estate is still probably one of the more accessible leverage strategies for investors, but you need to consider it a small business that requires hands-on work. For those wanting to boost their retirement income, buying real estate can worth considering provided you do your homework and ensure the numbers make sense.
For those who aren’t keen on being a landlord, real estate investments trusts (REITs) could be an option. These trusts invest directly in large residential and commercial real estate properties. Investors can purchase shares directly, through the stock exchange, or they can invest in a mutual fund or ETF that specialize in real estate. The benefit with REITs is that you benefit from diversifying your portfolio but with more liquidity (easier to buy/sell) than an actual bricks-and-mortar structure.
Another way to use leverage is to invest in your human capital and build a business. According to Statistics Canada, there are approximately 130,000 new businesses launched annually, yet, only 4% of these enterprises will continue after the first year. Despite the risk, many affluent investors have created their fortune by owning a business.
Finally, the simplest (but definitely not the safest) form of leverage, is borrowing on margin. Essentially, this means you borrow money and invest it. If the asset, such as a stock, increases in value, the capital gains are yours to keep. But if the asset price declines, you lose your own money and the money you borrowed. High stakes margin investing is certainly not for novices.
“Many people assume that leveraging is only for the ‘Richie Rich’. It’s not,” says Nord. “If you borrow money at one rate and can invest it at a higher rate, that’s a sound investment.”