dothesums blog

I watched an otherwise excellent BBC2 programme last evening on the generation of wealth in the City and the operation of hedge funds.

The term ‘leverage’ was used many, many times and was not described very well.

Leverage is possibly the number one reason for buying an investment property, because it enables the investor to profit from the appreciation of an asset, bought with borrowed capital.

Suppose we buy a flat for £100,000. We have a deposit of twenty percent, £20,000 and secure a loan of £80,000.

The bank has an investment of £80k, we have invested £20k. Our investment is one fifth of the price of the asset, the ratio is 5:1.

Suppose in the following year the value of the flat rises by £10,000 to £110,000 and we decide to sell. Ignoring other costs just for the moment, we have made £10k on our original investment of £20k.

That is, we have increased our capital by 50%. At this point the bank does not come along and ask for their 80% share of the £10K. All of the £10k belongs to the owner. The bank makes its money on the interest on the loan.

So instead of increasing our capital by 10% as the value of the flat has done, we have actually increased it by 50% a ratio of 5:1. This is leveraging. This return comes with a cost though.

The cost is the interest on the loan. If we can then let the property at a rent which covers this interest plus other costs such as insurance, the tenant pays for the loan, in full or in part.

Leveraging is not confined to property. Any asset can be leveraged, companies, aircraft, even football clubs.