The power of leverage

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Hey, everyone. It’s episode four of The Board. I’m really excited to bring to you a topic that has been on my mind for some time, but it’s come alive based on a client case study recently.

The customer that I’ve been working with has actually been in a position, or is in a position, where they’ve got a lot of cash in terms of their bank accounts. Now they were opting to look at a commercial property as their brief with me because they were really wanting to boost the income in their portfolio, but they’re undecided whether to use all their cash on this deal, or whether they use part lending and part cash, and keep some money aside for later to look at other things they could do.

So today’s whole topic is around the power of leverage, okay? Let’s talk about the power of leverage. For those who are new to this concept, in this concept of property it’s pretty much saying combining your money with someone else’s money, in this case the bank, to be able to leverage on this asset, and use it to perform more for us. Okay?

If we look at this scenario here, we’ve got $400,000 purchase, a commercial purchase, at 7.25% net yield, which brings us a rough income amount of $29,000 in rent. Now here’s what happens if you purchase this whole property in cash, and this is what the customer was discussing with me. If we put it all in, your net yield is still 7.25%, if not lower when you consider some of the upfront costs that come with purchasing property too. Now we are looking in the South Australia area at the moment, which is a good thing in terms of some of the government benefits for stamp duty, and it’s gonna see us have a waiver on the type of asset we’re looking at, which is gonna save the customer almost $15,000, right?

Now let’s have a look at if we go … let’s use some debt, and 70% debt, and use the power of leverage. What can this do for us? If we’re looking at a deposit of $137,000, which is what the customer was looking to put forward, they can and are in a position to put the whole 400,000 in, but they’ve decided otherwise, post this discussion as well as a weigh up of other factors. 137,000, if we have this rent of 29,000, and go, “All right, let’s use this rent to pay on the mortgage of 280 at an interest rate of 4.5%, we’re actually getting it slightly lower for this customer, which is fantastic thanks to our network of brokers.

Now if we’re looking at 4.5% as an average, that’s around 12,600 in interest only payments. If we take away the two, 29,000 in rent, 12,600 in interest only payments, the actual left over on how much we put in … don’t think of the whole $400,000 deal. Think of how much cash you actually put in. It’s actually a rate of return of 11.97%.

It’s funny, we don’t always look at the portion that we put in because that’s the power of leverage. That’s where we really need to talk leverage. What you put in, and the return you’re getting on that. It’s actually 11.97%. But then we say, “Let’s look at some risk planning, an effective risk planning, and talk about not just interest only. Let’s look at principal and interest,” which I’m a fan of because in these circumstances then we can discuss with the customer about multiple scenarios, not just say, “This is the decision.” Let’s look at choices.

So we looked at principal and interest. The principal portion of this rate based on a fast pay down 15-year loan term, is 13,104. Again, if you add these two figures together, it’s 25,704. So 25,704 is your principal and interest over 15 years, and we still have money left over as the net rent is 29,000.

Let’s see what’s left over. 3,296, and that amount is now passive income, not including depreciation, and that too on a principal loan, okay? This customer said, “Hey, Arjun, actually you know, I want to pay down the debt faster. Without really using my money, let’s leverage this debt, and use the rental income that’s quite high to pay it down.” So we decided we’ll take this 3,296, add it to our principal payments that this rent is making. And, again, put that onto the loan to see how much faster we can pay it down.

From 15 years, that comes back to around 13, and it’s actually just under 13. So we’re looking at 12.75-12.5. If we look at that, what’s our position 12 to 13 years from now? Now there are a lot of other factors to consider, and we won’t go into them in this video. For example, having vacancy periods, or having rent increases. But let’s just say for now these two sort of balance each other out, from you can increase rents in later years versus also vacancy periods. Let’s just focus on the simple example of the debt going down in 13 years.

Now if this tenant has paid this debt down in 13 years, and you’ve used your extra cash flow, assuming no extras, then what money did you actually put in? You still have only put in your 137,000. And if in 13 to 15 years from now, debt is gone, what is your actual return on your money? Again, we’re not factoring in rents increasing. We’re not factoring in interest rate changes. We’re not factoring in vacant periods. Let’s just have a look at it in the simplest of forms. This rent that they’ve got now leftover against the return of this amount of deposit, 137,000, actually ends up to being a whopping 21.17% return because effectively they’re now mortgage free, but they never put in their whole 400,000. They only put in 137,000.

In this period, the customer actually may put the money into offset. It’s their decision, or we’re looking at other investments. Again, their decision. So we can potentially use leverage without over-leveraging so their cash reserves are still high, but that’s just an example to show you the power of leverage, and what you can do if you’re using income producing assets with debt that’s managed appropriately.

That’s it, thank you.