Investors; What Makes You Think CASH is so Cool?

                 

        Depending upon what dictionary you consult you will get five to seven definitions of the word leverage.  Each of the dictionaries agrees there are two primary definitions.

1). the mechanical advantage gained by being in a position to use a lever.

2). Investing with borrowed money as a way to amplify potential gains.

You should take just a moment to reread both of the definitions because when we talk about Financial Literacy, and the use of leverage in the Game both definitions apply.  Clearly the second definition is directly related to matters of finance, but I offer that the first definition is as well, particularly when we talk about leverage as the most successful strategy in the Game.  Leverage provides an advantage, it is the principle of acquiring more with less.  A high net worth Investor with moderate liquidity could purchase ten, $100k single-family homes in cash; a $1M investment and nice addition perhaps to their portfolio. Applying leverage the same Investor, with the same capital investment $1M could acquire one hundred, $100k homes, assuming a 10:1 leveraging scenario.  It is the advantage of leverage, the ability to acquire more by applying the principle of leverage. No different than how a system of pulleys and levers allow a man of average strength to lift or manage a superior weight load, leveraged finance can afford an Investor of average means the ability to acquire more substantial assets.  An Investor of average means could for example apply a leveraged finance scenario to acquire those initial ten, $100k single-family homes with a capital investment of merely $100k, presuming the same 90 percent loan/value finance solution.  In finance, the smart Players apply leverage to maximize their investing capability and their liquidity.

Understand that leverage is an investment strategy which can be used across the board for stocks, bonds, commodities, currencies and multiple other investments.  True Players are employing leverage strategies in many facets of their wealth portfolio. Professional Traders, and even Bond Market Investors can employ such strategies; for example, a Bond Investor can capitalize on the differential between short-term interest rates and long-term rates by borrowing at one, and investing at the other.  There’s profit to be realized in the offset.  In the Game, some of the more advanced leveraging strategies can be quite risky for the uninitiated as you must remember, losses are also magnified.

No matter the use, leverage generally involves the use of funds not your own.  Generally speaking, the use of others’ money has a cost, the cost of funds, or interest as we call it most commonly.  Cost of funds is one of the factors in leveraging you must be cognizant of in order to mitigate the overall risk.  If you are going to use leverage be certain to consider the cost of funds in your risk exposure analysis, not doing so can be detrimental.  Earlier I gave an example of the most basic leverage application which is the use of leverage to acquire real estate.  In my example an Investor with $1M in cash used leverage in just a 10:1 ratio to acquire one hundred, $100k houses.  If our Investor liquidated shortly thereafter and sold each house for $110k he would have garnered a $1M profit, a 100% return on the original capital investment.  In the same example, on the other side of the coin our Investor did not employ leverage and instead paid cash for ten of the $100k houses.  If he were to liquidate his 10 houses in the non-leveraged scenario at $110k/house, the profit would be merely $100k or a 10 percent return on the original capital investment of $1M.  As any Investor will concur, a 10 percent return is good, but a 100 percent return is stellar.  This is an example of how leverage can maximize the use of resources for greater capability and return.

It’s important to comprehend debt, understand that not all debt is

bad, some debt is good. So how do you know the difference? Good debt is debt that is paying you a return, or debt finance perhaps taken on to acquire an asset which is providing you cash flow.  An Investor who purchases a $500k income producing asset using an 80 percent loan-to-value debt finance scenario takes on $400k debt.  Let us stipulate that the monthly PITI, or Principle, Interest, Tax, and Insurance payment is $2,400 and the gross income from rents is $3,400 per month. If we additionally factor 5 percent annual appreciation and 3 percent annual rent increase, this becomes a really good looking investment. In this scenario, there is a net cash flow of $12k annually so you can attribute a cash-on-cash return on the original $100k capital investment of 12 percent.  Of course these are rough calculations, and I have not included property operating expense, nor a vacancy allowance, but you can see that the decision to take on the debt is paying dividends. This is good debt.

Had leverage not been used in this scenario the cash-on-cash return would have been a mere 2.4 percent, but the equity would be substantial and the property would be debt free.  However, an Investor with $500k in cash could apply a leverage strategy and could have acquired multiple properties in this scenario. In the realm of finance leverage comes in many different forms and can be configured, and applied in many different strategies.  It is the most basic and most important component of the Game. Your Financial Literacy must include an in depth comprehension of leverage, particularly as it relates to debt finance.  Your Financial Literacy must also include a comprehensive grasp of the mathematics of investing.  Understanding the math of investing and finance will increase your ability to make sound investment decisions and will mitigate your risk when acquiring debt.

As your Advisor, I can certainly help you to employ a debt financed acquisition and portfolio strategy to achieve your Investment objectives. Let's talk about it: dameon.russell@ersfunding.com.