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The beauty - and beast - of leverage
Analysis by Dianne Maley
November 10, 1989
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Ever wonder how the rich get rich?
Well, to start with, they usually have some money. But to turn a little
bit of money into a lot, you have to follow religiously the golden rule of
investing: borrow in boom times and retrench when things begin to slow.
The magic tool is leverage. Real estate investors know it well. In times
of rising house prices, you buy a property with a little of your own money and
a lot from the bank. Say you put $10,000 down on a $100,000 house; the rest
you finance by taking out a mortgage on the property.
Over the course of the following year, the house price rises by 10 percent
to $110,000 -- not an unreasonable thing in a healthy market. You have made a
100 percent return on your money in one year.
In a really hot market, house prices can rise even faster, making the
returns stunning. This is the beauty of leverage.
As we have learned from the U.S. takeover binge, leverage is not limited to
real estate. When a big corporate raider wants to take over a company, he
borrows against the assets of the target company to pay for it. Then he pays
the debt back with its earnings or by selling some or all of its assets.
This is known as a leveraged buyout, in which little of the purchase price
comes from the buyer's pocket. The buying companies have made so much money
doing this in the past while that they have lost interest in the stock market.
Why buy stocks when you can buy the underlying company, break it up, sell the
parts and make a huge profit?
But when you are starting up a company, leverage may not be the best tool.
Often, the start-up period turns out to be longer than you expected and the
costs higher. If you are relying solely on your bankers, you run the risk of
having them pull the rug out from under you before you have had a chance to
get going.
If you have an established business and you want to expand, though,
leverage can work nicely. You can borrow against your existing plants to
build a new one, for example.
By and large, small investors have learned the leverage game well. Where
they go wrong is in not knowing when it is time to reverse the strategy.
Delightful as it is on the way up, leverage works in reverse on the way down.
Your holdings can collapse like dominoes.
To use leverage with the family home is downright reckless.
The problem is to recognize when the tide has turned. Is your business
about to boom or bust? One clue is interest rates. When the difference
between what you are paying to borrow money and the inflation rate begins to
widen, it may be time to retrench. A spread of more than five percentage
points is a warning sign.
Currently, the real or inflation-adjusted cost of borrowing money ranges
upward from six percentage points, high by historical standards. The path to
riches is littered with the bleached bones of investors who did not heed this
sign.
Often, people overextend themselves so that when the time comes to lower
their debt load, they have no money left with which to do so. This points to
another investment rule: what if? Smart investors always ask themselves, what
if real estate prices fall by 20 percent rather than rise? What if oil prices
plunge? What if the stock market crashes?
To use leverage properly, you have to have assets in reserve so you can
reduce your debt before it reduces you -- to insolvency.
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