Have you ever wondered how private equity (PE) funds, hedge funds and other such private pools of capital, are able to generate extraordinary returns in markets that appear to be behaving quite ordinarily !?! Besides the genuine genius of some managers who manage these funds, they use a weapon which in normal circumstances is not available in large quantities to individuals and that is called Leverage. In keeping with the spirit of this blog which is to democratise access to "intelligent analysis", I would like to share in this particular writing how individuals can maximize returns in RE investing by using leverage.
Leverage (or gearing) can be loosely defined as, using given resources in such a way that the potential positive or negative outcome is magnified. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity. I feel the best way to illustrate its affects on returns would be through a few examples. By the end of it, you will appreciate why leverage is often called the cocaine of financial markets! Just like the real thing, its consumption can take you to great heights and its misuse can destroy you.
Example 1:
(A)Purchase price of apartment = Rs.1,00,00,000
Self funding (15%) = Rs. 15,00,000
Home loan (85%) = Rs.85,00,000
Rate of interest (ROI) on loan = 11%
Period of loan = 15 years
Equated monthly instalment (EMI)= Rs.96,610
Expected price appreciation in property =12% p.a. (with a GDP growth rate of 8% p.a., I believe, this is a realistic assumption for the 5 year period in this example)
Period of holding property before reselling =5 years
(B)Property price at end of 5 years (assumed 12% compounded growth) = Rs.1,76,00,000
(C)Interest paid over this 5 year period = Rs.43,10,092
Therefore, profit from transaction = (B)-(A)-(C) =Rs.32,89,908
The important point to be noted here is obviously the effect of leverage. As an investor, your equity in the transaction was a mere Rs.15,00,000 and you made a profit of Rs.32,89,908 in the 5 year period. Therefore, as an investor, you tripled your investment in 5 years. Ofcourse, the one big assumption in the example is that you are able to get a loan sanctioned and can afford to pay the EMI of Rs.96,610 for 5 years. If you get regular income either in a job or are self employed, most banks would be willing to extend this loan to you.
The above example was to show you the effect of leverage. Ofcourse, the amount you borrow can be increased or decreased based on your repayment capacity. Keep in mind that the more you borrow (based on assumptions in example above), the more your returns will be accentuated. Ofcourse, if some of the assumptions change, the outcome could be painfully different as I will illustrate in example 3.
Example 2 (No leverage):
Let's assume the identical secnario as described in example 1 except without leverage.
Investors equity =Rs.1,00,00,000
Profit at end of 5 years =Rs.76,00,000
Therefore, in this scenario, the investor made Rs.76,00,000 on an investment of Rs.1,00,00,000. This means the investor failed to even double his or her money as opposed to tripling the investment with use of leverage as in example 1!!
Example 3:
Let's assume all things remain same as in example 1 except for 2 things-rate of interest on loan and expected rate of appreciation of property.
(A)Purchase price of apartment = Rs.1,00,00,000
Self funding (15%) = Rs. 15,00,000
Home loan (85%) = Rs.85,00,000
Rate of interest (ROI) on loan = 12%
Period of loan = 15 years
Equated monthly instalment (EMI)= Rs.1,02,014
Expected price appreciation in property =7% p.a. (you may have assumed a higher growth but your assumption could be wrong and you may end up with only a 7% growth or even lower)
Period of holding property before reselling =5 years
(B)Property price at end of 5 years (assumed 7% compounded growth) = Rs.1,40,25,517
(C)Interest paid over this 5 year period = Rs.47,31,306
Therefore, profit/loss from transaction = (B)-(A)-(C) = (-) 7,05,789
Now, that's what is a bad outcome of using leverage. As an investor, you could actually lose money by using leverage. In this scenario, if you had not used leverage, as an investor you would still have made a profit of Rs.40,25,517 or 40% on your investment of Rs.1,00,00,000. By using leverage, the investor could lose Rs.7,05,789 due to the cost of interest! Careful-learn to consume cocaine before you do.
This is a fascinating subject and almost perfected to a science by the financial engineers working at large banks and funds. Suffice to say, as an investor you can use the use same principles and magnify your returns.
What are you waiting for ?
more later,
Ashish
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5 comments:
I think leveraging is extreamly imp in such major investment decisions...however, one should mention and take into account the overall economic situation of the region, forecats for the RE market and their own disposable income..rule of thumb---your monthly installment should never be more than 33% of your gross monthly income..more later
Hey Captain, Good to see you participating on the forum. I agree with your point regarding affordability-taking out a loan without understanding one's ability to repay can be dangerous (think....US subprime crisis). Needless to say, the loan approval process by banks will act as a first level filter. Therefore, a bank should normally reject an application not supported by the desired income level (ofcourse, we know that doesn't always happen or there would have been no sub prime crisis in the US).
If this 7-8% appreciation is correct, what happened to investors from 1993-2001. The RE market was flat for all these years. I'm very surprised at your audacity to fool people with your numbers.
You are such a jerk. Provide at least 10-15 years data and not the last 4 years. EVeryone knows that prices went up by 30% every year.
Hi ashish,
Interesting blog. I tend to agree with your suggestions that smaller apartments in delhi(particularly south delhi) in good localities would be a good bet for investment/rental returns. My question is where do I find new builder apartments with sq. ft. areas of 1100-1300 sq. ft. in south delhi. The ones available are built in 125-160 sq. yds. which have no air/sunlight/parking and are terribly cramped as a neighbourhood. The ones of DDA like sarita vihar and vasant kunj are very old and dilapidated. So what are the options????
Anuj
Hi Anuj, Thanks for participating in the discussion. Your point is well taken about non availability of small apartments. As you have correctly pointed out, some of the options available have limitations. However, I feel, if the price is right, DDA apartments can offer some good investment opportunity. The other trend I see emerging is people investing money in older properties to spruce them up. Afterall, DDA has apartments across the city at prime locations and this supply cannot be allowed to rust. With the right amount of investmentment in sprucing up, I feel these aptts. will be great rental options for young couples, out of town students, singles, etc.
Other than that, you might find 2BR options in areas such as EOK, Chittaranjan Park, Kailash Colony, GK, etc and not necessarily on small plots.
Infact, I would benefit from your research as well. So, if you find some interesting buys, please share with us on the forum.
Pl come back to the blog for some fresh ideas and to share your thoughts.
More later,
Ashish
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