How debt can magnify your return – and your risk

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How debt can magnify your return – and your risk

Property investment has a distinct advantage over most other asset classes (at least for the “ordinary man in the street”), in that loans are more easily obtained to fund the investment (despite the introduction of the National Credit Act). Using debt to improve your return on equity is called gearing or leverage.  A high debt ratio (like driving fast in fifth gear) “gets you there faster” (in other words, improves your return on equity, provided that the market and other variables support you), compared to a lower debt ratio.

It is a two-edged sword as a high debt ratio not only magnifies your positive returns, but negative returns as well. A highly geared investment will improve your return on equity if things go well. You could thus accumulate more wealth faster than you otherwise would have done. But, if you are highly geared and the market turns against you, causing losses, these will similarly be magnified. This could even result in you losing your property.

Your ability to hang on to a property is influenced by the rent you receive (or don’t) and the interest rate on the home loan.  If there is no debt on a property, and the tenant can’t pay the rent, you can likely survive for months, perhaps even years, even having to pay the monthly property costs.  Even if debt is, say, 30% of the value of a property, you should survive high interest rates.

But as debt rises, say to 80%, 90% or over 100% of a property’s value, changes in interest rates and rents can have an enormous effect on your ability to meet your obligations and hold on to a property.  The higher debt is in relation to the value of a property or to net rent, the more sensitive the investment is to change and the more volatile the income.

As explained above, risk increases with debt. The higher the ratio of debt to property value or net rent the greater the risk – but the greater the potential return.  You are in greatest danger when you increase the debt on a property at a time when the environmental risk is high, perhaps when a property bubble is bursting, the economy is diving or interest rates are rising.  Of course, time becomes a factor in reducing the risk on a property.  As the value grows and rent rises, the bond becomes a lower percentage of both and the risk falls.

Your first duty to your investment is to hang on to it through all but the worst possibilities.  This boils down to an ability to pay your home loan instalment on time, or if the worst comes to the worst, to sell the property quickly and repay the full home loan.  The less you borrow, the more likely you are to be able to do that.

The smart approach is to treat your property as a bank, leaving the equity in to build up low-tax gains, while you restrain yourself from buying that fancy car or great holiday the property equity can easily pay for.  Draw on that equity when you have a really good investment proposition, perhaps as the deposit on the next property.

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