Leveraging Real Asset to Build Wealth

By
Telukunta Sai Kinnera,
Leveraging Real Asset to Build Wealth

There are huge opportunities to yield wealth in real estate investing. It is all about making clever decisions and taking strategic risks. And the significant step of any investor is to get hold of those opportunities that the sector offers and generate the highest return possible with minimal risk.

One key metric that the investors can make use of and reap wealth is the ‘leverage’. The term leverage has various definitions and has slight nuances depending on the context it’s being used.

Leverage Definition

About real estate, leverage means to use borrowed capital to enhance the return of your investment. In a simpler way of putting it, leverage is a debt. Debt is quite a scary thing for many people, and there is no doubt that everyone should be prudent with taking on debt. However, there are both types of debts- good debts and bad debts.

  • Good debts help people attain their goals. For instance, many people cannot think of home-ownership if it weren’t for mortgages.
  • Bad debt is what leaves people behind and throws them into a vicious cycle of debt traps. Examples of bad debt may include unfulfillable credit card balances or payday loans with enormous interest rates.

Common Debts Used For Leveraged Investment

There are a few types of debt that can be made use of as leverage for investment purposes. Each has its unique role while investing, and each has its specific considerations.

Traditional Loan

This type of leveraged investment is one of the easiest for an average retail investor to understand. If he/she wishes to put in a lump sum of money, then they can reach out to a financial institution for a loan.

Margin Investing

Another very frequently opted method for leveraged investment is to invest using margin. This is the case when an investor can use the power of their portfolio almost like security to invest the borrowed(from the debt taken) money granted by their brokerage. A 2:1 margin ratio must be maintained, which means that for every 2 rs worth assets an investor owns, they should be granted 1 rupee in equity.

For a better understanding, let’s take an instance. Suppose an investor wants to avail a debt and owns an asset worth 50 lakhs, he/she can be granted a debt of 25 lakhs or some amount closer to it. With about this 75 lakhs, he can proceed with another investment. Thus, this method helps the investor in diversifying his/her portfolio and building wealth.

One of the main benefits of investing on margin is: as portfolio size becomes bigger, more margin becomes available.

Futures Contracts

Futures contracts are not generally something that an average investor will be directly involved. Yet, they may choose or prefer to invest in funds that deal with future contracts as a part of their overall investment plan.

These contracts give investors the ability to invest at a future date for a determined price. For instance, if an investor feels that an investment will gain value over a certain period of time, then they can buy a futures contract at or closer to the current price of the investment.

These contracts are a great way to mitigate risk, but they are a bit complicated investment instruments. Retail investors that do not have a good understanding of the concept of futures contract should avoid these investments until and unless there’s proper guidance. However, if used properly, futures contracts can be one of the most cost-effective ways to obtain leveraged returns.

Options

Options can be used as leverage when an investor believes that the chosen asset will either gain value or lose value. An option will have two very important details:

  • Strike price - It is the price at which the option can be exercised for a profit.
  • Expiry date - It is the date when the option contract expires.

If the strike price is not met, the investment will be worthless for the investor.

When buying options, investors pay a premium which is handed over to the seller in exchange for writing the option. A premium is generally priced far less than what the current market price of the underlying asset is. This limits the downside, i.e. the risks for buyers of options.

Exercising Leveraged Funds Option

For investors who do not want to take leverage directly, there is an option of purchasing leveraging funds. These funds try to beat average market returns. For example, investors can choose a fund that tries to double the performance of the S&P 500 utilizing leverage.

These funds will use different strategies like borrowing 30 rupees for every 100 rupees in holdings to buy contracts like the ones mentioned above. Also, they help take the responsibility of leverage away from the individual investor and create the potential for abundant gains. However, the pitfalls of leverage are not eliminated. If by chance, wrong decisions are made, and fund managers take wrong moves, losses can be amplified.

Reason to Choose Leverage to Maximize the Returns

Most investors generally do not have the funds in hand to make outstanding investments, and, as a result, they may have to invest slowly over time. This means that there is a chance of missing out on plentiful gains just because they don’t have a lot of skin in the game. But, by using leverage for investment purposes in such cases, investors can purchase assets and therefore, experience significant returns.

Risks Associated with Leveraged Investment

Nonetheless, there is also a downside to leveraged investment, and it is the risk associated with losses that may be resulted from depreciation, interest rates, etc. Also, if managed unwisely and irresponsibly, it may land up the investors in a devastating situation.

Case Studies for Better Understanding

Here are examples of how leverage can escalate your returns or leave you down in the valley.

The Positive Scenario of Leveraged Investment

If a real estate property costs around one crore, and if Preetham can afford to pay 50 lakhs from his side, then he can use a leverage of 50 lakhs at 5% and buy the property.  Now, a year later, let’s assume the property appreciates by 10%, then the total property value becomes 1.1 crores. Assume this property is sold at 1.1 crore rupees. Now, the investor returns 50 lakhs principal amount along with the interest of 2.5 lakhs, i.e. a total of 52.5 lakhs. So basically, out of the 1.1 crores at which the property was sold, the investor returns 52.5 lakhs to the financial institution that provided him leverage. Now, subtracting 52.5 lakhs from 1.1 crores gives 57.5 lakhs, which is the investor’s amount. Here, it is evident that the transaction fetched an extra 7.5 lakhs, i.e. 7.5% profit to the investor in just an outstanding year!

In this way, he also can generate rents in the meanwhile and pay the interest amount to the financial institution from the obtained rents itself. This is an added benefit wherein investors not only get to own the property but also generate rents, capital appreciation of the property, and stay on the profits side of the coin.

The Negative Scenario of Leveraged Investment

Taking the example mentioned above itself, let’s assume the property’s price depreciates by 10%, i.e. becomes 90 lakhs. And, now, if this asset is sold at 90 lakhs, and out of that if the investor returns all the debt-money, i.e. 52.5 lakhs to the funding institution, he will only be left with 37.5 lakhs which is a tremendous loss of 62.5%.

Such is the mighty power of leverage! Just with a 10% appreciation or depreciation, the whole game can take a turn.

Summary

It is very crucial for investors to understand the amount of leverage that is used in any real estate project they are considering investing in, to apprehend that a higher-leveraged situation could represent a more substantial loss in the scenario of a market downturn, and ensure they are adequately compensated for the level of risk taken. Thus, debt can be dead scary, but if used in the right manner, it has a tremendous potential to yield enormous returns.

FAQs:

About real estate, leverage means to use borrowed capital to increase investment returns. In simpler terms, leverage is a debt.

  1. Traditional loan
  2. Futures contracts
  3. Options
  4. Investment on margin

Most investors typically do not have enough funds in hand to make heavy investments, and, as a result, they may have to invest slowly over time. But, by using leverage for such heavy investment purposes, investors can afford to purchase assets and therefore, yield significant returns.