Why do Property Investors use Leverage to Maximise Their Returns?

The following case study outlines the reasoning why it is financially beneficial to use the banks money to finance property investments rather than ones private reserves. Lets assume that we are purchasing a property for 100 000 and that property inflation averages 10 percent per year over a 5 year term. (I have specifically left out the currency as this example can be applied to any country.)

Your Capital Growth on the property would look as follows:

• Year 1: 100 000 + 10 000 (10% growth) = 110 000
• Year 2: 110 000 + 11 000 (10% growth) = 121 000
• Year 3: 121 000 + 12 100 (10% growth) = 133 100
• Year 4: 133 100 + 13 310 (10% growth) = 146 410
• Year 5: 146 410 + 14 641 (10% growth) = 161 051

Case 1:You use your own personal savings to finance your acquisition

In this case you would have made no more than the average rate of property inflation. In other words, you would have made a return of 10% per year plus of course any rental income that you may have received less any property related expenses that you may have incurred.

Your initial investment of 100 000 would have yielded a return of 61 051. This is a rather poor return on investment of only 61% over the 5 year period.

Alternatively you look at the advantages of leverage or as it is also commonly referred to as gearing.

Case 2: You put down a 20% deposit and use the banks money to finance the balance

In this case your investment would have cost you 20 000 of your own money and 80 000 of the banks money. The trick of course is to try and find property that will yield a rental return that will cover your bond repayment as well as any costs that the property may incur.

Having used the leverage of the banks money, your initial investment of only 20 000 would still have given you the 61 051 return. This gives you an excellent return on investment of 300% over the same 5 year period.

My Conclusion:

Although these are overly simplified figures, they do show the general underlying advantage of using the banks money as apposed to your own. In case 2 you could theoretically have applied your 100 000 to purchase 5 properties and then made 61 000 on each of them.

What is however important to remember is not to over do it. Don’t leverage or gear your properties to such an extent that it creates a cash flow problem for you. Try balancing your investments so that the rent you receive can cover your bond repayments as well as any additional monthly costs that the property incurs. You may have to suffer a slight shortfall for the first couple of years, but as the rental escalations start to come through you will soon be breaking even and after a while you will begin to make a monthly profit. At this stage, rather than starting to declare a taxable income, it may well make more sense to refinance the property and use the proceeds to expand on your portfolio. After all the real money is to be made in the capital growth and not the monthly rental income that you will receive.

Bradley Hancock is the founding member of Portfolio Property Investments, a web based property investment company that offers its clients expert advice on property market trends and specializes in putting together offshore property investment packages on behalf of their client database.