INSIGHTS

LEVERAGE CAN BE A DOUBLE-EDGED SWORD

Mark Lister, 30 November 2016

Borrowing money to invest can supercharge your returns but only in a rising market which is difficult to time.

There has been a bit of commentary recently proposing New Zealanders use the equity in their homes more aggressively to grow their wealth. We’ve even heard suggestions that people borrow against family members’ homes to get into the property game.

This isn’t necessarily bad advice. Most wealthy people have gotten where they are by taking risks, and this often means borrowing to invest in something, be it real estate, businesses or farmland.

The financial term for using other people’s money to invest in something is “leverage”. In a rising market leverage can make you very wealthy, supercharging your returns and leading to the massive gains many property speculators have enjoyed in recent years.

However, it comes with a catch. In a flat or falling market leverage can do the opposite, by magnifying your losses. That’s the tricky bit when it comes to borrowing to invest. The timing is crucial and the concept only works if asset prices are rising.

If you’d borrowed against your parents house three years ago and invested the money in Auckland houses, you’d be patting yourself on the back.

With prices up close to 50 per cent and returns on your small deposit much higher, you might even be tempted to use some of your newfound equity to borrow even more and do it all again.

But will those large gains continue over the next few years? I would suggest that’s highly unlikely, given the strength of recent years, and with interest rates now rising from all-time lows. A highly-leveraged investor isn’t quite as well positioned to make a quick buck if we’re heading into a sideways market.

There’s still a hefty interest bill to service, as well as maintenance, insurance and other costs to take care of. If the rent doesn’t cover those, you’re reliant on capital gains for the investment case to stack up.

Worse still, if prices are falling you can end up with an asset worth less than what you owe the bank. To add insult to injury, you’re still tipping money in just to cover running costs, sending you further backwards.

We’ve all heard the rags to riches property investment stories that make it all sound so easy.

These tales usually have two vital ingredients, lots of leverage and a strongly rising market. The first of those is relatively easy to achieve, but timing your run to coincide with a strong rally in asset prices is much more difficult.

Many of these successes are a case of people jumping on the bandwagon at the right time, rather than any great investing nous.

Debt can be a great tool if used wisely, and people need to be prepared to take some risks to build their wealth. However, investors can also end up on the wrong side of the equation if they borrow heavily at the wrong part of the cycle.

This article was published in The New Zealand Herald on 30th November 2016.