By Doug Wroe

Last week we looked at the two key measurements of investments, Return ON Equity and Return OF Equity and then moved on to the Drivers of Wealth.

Read Drivers Of Wealth

• Leverage
• Compounding
• Inflation

Over the next few weeks I will dig deeper and unravel these three topics; starting this week with the First Driver Of Wealth – Leverage.

Leverage

Leverage is basically gearing. As in your car you cannot go at 100 km/h in 1st gear. The engine just can’t turn over that fast. It is through gearing that you are able to move your vehicle faster when the conditions allow. Essentially you are getting more turns of the road wheels for fewer revolutions of the engine.

In 400 BC Archimedes said “Give me a lever long enough and a fulcrum on which to place it and I shall move the world”.

What he was referring to was that, provided he had enough leverage or gearing, he could move any object with little effort. In a financial setting the meaning is very similar… being able to move or control larger amounts of equity or money by using a smaller amount. Let me give you an example:

Option One

With $100,000 in cash you could buy a $100,000 asset with no debt and wait for it to increase in value. Assuming growth is 10% per annum, the Return ON Equity would be 10%. That is, your $100,000 investment has returned an additional $10,000.

Option two

By using gearing (another term for leverage) you could perhaps borrow an additional $100,000 and purchase two assets as above with a 50% LVR (Loan to Value Ratio). This 2 to 1 gearing ratio allows you to control two x $100,000 in assets; or one x $200,000 in assets.

For the same input as Option One, Option Two doubles the output, or return. This is moving into 2nd gear.

• 10% capital growth x ONE $100,000 asset  = $10,000
• 10% capital growth x TWO $100,000 assets = $20,000

While Option Two means you will have a debt of $100,000, the return on your initial $100,000 is twice what it would have been had you NOT leveraged (or geared) your initial investment. This return of $20,000 represents a 20% Return ON Equity.

NB: Ignoring individual costs for simplicity, let’s assume the income from the assets in Option Two are sufficient to neutralise all holding and transaction costs; such as interest payments etc.

Moving Into Top Gear

Expanding on the above example…

It may be possible to borrow as much as 95% against some assets such as residential real estate. That is a 20 to 1 gearing ratio. If that asset rose by 10% (as in the previous example), the return for your input would be 200%. You contribute just 5% but control 100% of the asset… and own 100% of its’ growth in value. 10% growth in value is twice the 5% you put in.

NB: You still owe the bank the 95% of the original price but all the increase is yours to keep after any relevant transaction costs are taken into account.

You do not have to own the asset to harvest its growth; you just have to control it.

This very basic principle is how my wife and I have maintained a 33% Return ON Equity with, in our opinion, a negligible risk to our Return OF Equity. I know many people who are averaging a much higher figure than this.

By now you may be thinking… “how much leverage can I get” or “how high can I gear”; however, it’s VERY important to understand that YES, gearing magnifies your gains but equally it will magnify your losses. The higher you gear your investments the higher your returns will be, but as you embrace higher gearing ratios, the more stable and predictable the asset you choose ought to be.

NB: Remember mrd promotes ONLY responsible debt management and we are happy to discuss this with you further on an individual basis.

DO NOT LOSE SIGHT OF RETURN OF EQUITY WHILE YOU ARE CHASING RETURN ON EQUITY!

There are some asset classes that will allow you to gear higher than others. I have often read that buying shares or a managed fund becomes increasingly risky as you pass the 50% gearing level. That is a 2 to 1 gearing ratio. There are some products available through the stock market that allow for a 100 to 1 gearing ratio. Personally, these are too risky for me; I would be concerned over my Return OF Equity. Others are happy to speculate and take such risks and some do well.

Some time ago I looked at how much Westpac were prepared to lend against their own shares. At the time it was 75% yet they were willing to lend 95% against my house. That is a clear demonstration that they are more confident in the value of my house than the value of their own bank shares. They will allow me to gear higher in this asset class because the risk to their Return OF Equity is lower.

The majority of banks are comfortable gearing conventional residential property up to 80% or more. At 80% you have a 5 to 1 gearing ratio. For every dollar you put in, the bank puts in four, giving you the power of 5 times your equity in the market. If we use 10% per annum growth, as in the above example, your achievement would be a 50% Return ON Equity. NB: this is a simplified example to demonstrate a point. Real examples we prepare would show ALL costs associated.

Hopefully by now you will understand why offers of 5%, 8% or even 12% return on my money fail to even grab my attention.

The opportunities to gear into these asset classes are very limited so the advertised return is about all I can hope to achieve. By choosing relatively safe asset classes and using gearing or leverage wisely I can achieve much greater returns. If you then compound those returns year after year the end result is significantly different but that is the topic for next week’s article.

The Bottom Line

Leverage allows us to build our family’s wealth and how we do this is so very simple:

Safely control the largest asset base you can, using the least amount of your own equity!

Over the next few weeks I will continue this series, designed to give you a clearer understanding of the Drivers Of Wealth. Next week I will speak about compounding.

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If you would like one of our property mentors to run through a Personalised Retirement Options Plan (PROP) and let you see for yourself the possibilities (knowing there will be no cost or pressure to do something) then let us know. If you have dreams and goals but are unsure of how to turn them into reality, I strongly recommend you speak with us.

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Happy Investing,

Doug Wroe
mrd Customer Care Program… because investing is personal