How leverage works using a mortgage
Published ¤ 27/08/2010 15:33:04
Many of us have heard about it, but what is leverage with respect to property investment, and how can one make the best of it?
What is it?
First we need to understand what leverage is. In very simple terms, leverage is using other peoples money (usually in the form of a loan or mortgage, either direct from the lender, or from the property developer) to amplify the potential gain from an investment over a fixed period of time.
For leverage to actually be leverage, it does technically rely upon an end date to be calculable. Taking out a mortgage on your house is sometimes regarded as leverage, although if you don't sell the property, it is for all intents and purposes just a long term loan.
A clear example is if you take advantage of a section of time in an investment. In this case, the investment into a property that you intend to sell in after a year. If you were to place a 10,000 deposit on a 100,000 property, you would need to borrow 90,000.
If the 90,000 that you have borrowed costs you 5% in interest, it would add 4,500 to the overall cost, meaning that the 100,000 investment is now actually 104,500, provided you sell the property within the time frame (1 year)
In order to make a clear profit from this exercise, the property would need to be sold for more than 104,500, so let's say it is sold for 110,000, realising a clear profit of 5,500.
Now, in order to show the difference in actual profit between outright cash payment and using the example above on the proviso that the investment is sold within the timeframe for 110,000
The difference in profit as you can see is substantial as far as percentage gain on capital is concerned, provided the whole transaction from start to finish takes place within the calculated time frame.
Like any form of speculation, there are things you need to keep an eye out for. What many people get caught up with in this seemingly simple tool is time span. For example, if the market does not perform as well as one would hope, lets look at the numbers if the investment only sells for 102,000.
All of a sudden, we find the investment is actually costing us money instead of making it!
How does one get the best out of leverage?
Given market volatility and the inherent lack of liquidity in physical property itself there are a number of things to be taken into consideration. In the recent property boom years, many were encouraged to place deposits on multiple off plan properties under the premise that the market would continue to boom and still be as strong, if not stronger by the time completion was due. If it had been, the property could have been sold, and the transaction would have been a great success. In most cases though, the market had taken a turn for the worst, the number of buyers had waned significantly and many were left to complete on properties they didn't need or want, with ongoing costs in the form of unplanned mortgage payments.
The key to success is ensuring that a secure exit strategy is in place. Whether that is a guaranteed buy back from the developer, promoter, or resale of the unit before more costs are incurred. If you are able to guarantee also what that minimum buy back value is, you have the closest thing there is to a fool proof investment.
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