Looking at Leverage

Jul 01, 2018

There is obviously a substantial difference between the industry of residential property – and the industry of commercial and industrial property. Aside from the obvious – that residential is in the main owner-occupied, and (in the main) the owner’s major asset – very often the motivating factors for the purchase of residential are emotive, and for commercial / industrial they are financial.

It is worth examining one of the financial aspects of industrial property, as very often in the day-to-day business of dealing with these investments, we can lose sight of the over-riding reasons for investment – as in not being able to see the forest for the trees.

Our guiding mantra for some time has been the comparison in returns between different forms of investment. The primary comparison we use are bank interest rates; industrial property and active businesses.

Leaving your money in the bank has a reasonable guarantee of security – in New Zealand at least – that your money is safe and you will get it back. Additionally you will earn an interest rate of between 1 and 3%, and at the end of the term your money will be worth a little less in buying power than it was at the start. But you will sleep well knowing that your money is safe.

At the other end of the scale, if you invest in a small to medium business, you will need to actively manage it. The business may grow, or diminish, in value over time. But during that time will take constant supervision  and driving. And you may achieve a return in the range of 20% to 35% plus. In between those extremes (in return, security and involvement) there is commercial / industrial property.

You will still need to manage the investment. But it is not hands on , and not 24/7. And ultimately the property may be worth more than you paid for it, whilst in the meantime achieving somewhere in the 4% to 8% return on investment.

So, in brief, there are the options:

Safe 1 - 3% No capital gain, probably minor loss in purchasing power  Totally hands-off management
Some risk 4 – 8% Potential capital gain  Some management input
More risk and committment 20 - 35% Upside and downside risk   24/7 management commitment

But there is more! Particularly with regard to the need for additional capital, and the potential to leverage. Both industrial property, and to a greater extent a stand alone business, can require from time to time additional capital. With an industrial building it may be a new roof, or with a business new machinery. The need to find and inject additional capital into these investments is often something owners neglect to budget for.

Most people are aware that they can borrow substantially against the purchase of residential property. At one stage it was generally 90%, but now more normally around 80%.

However, commercial/industrial borrowing is generally limited to 50%. Even at this level, there is leverage to be obtained which doesn’t apply to leaving money in a bank, and has less relevance to owning a business.

Let’s take a fictitious example with some round figures, to illustrate the point.

A property can be purchased for $1M. It returns (on paper) 6% - which , say, converts to a real world yield of, say 5%. That’s an actual return of $50,000 – putting aside any potential capital gains. Let’s say the purchaser is financed at 50% at  6%.

This means the initial investment is only $500,000, the return is $50,000, and the cost of borrowing is $30,000. Which equates to a $20,000 return on the investment of $500, 000 – or 4%.

What therefore, is the argument  for borrowing to finance a purchase, when the net result is less than not borrowing?

That’s where it gets interesting. If yields  move up – say to 8%, and interest rates remain the same, the numbers change to $70k rental, with $30k interest bill, meaning a $40k return on investment – or 8%.

Conversely, back in the days when yields were about 12%, but interest rates 25%, the numbers for a similar property would have been  $110k rental, with $125k interest bill. In other words, being leveraged (if a bank would lend to you) resulted in a negative return.

Accordingly, when and how much, is it prudent to leverage ?

The key factors are:

1)      Leverage enables the purchase of a larger property, which can increase the risk factor, but also increases the potential size of the capital gain – should there be one.

2)      By leveraging a purchaser potentially increases the distance from purchasing competition. There will generally be more competition for properties with a lower dollar value – thereby depressing yields.

3)      The biggest factor is the gap between interests rates and yields. The greater the  gap, with the proviso  that the yield is greater than the interest rate, the greater the advantage leverage provides.

Whilst leverage is an accepted part of residential property investment, primarily because residential investment is focussed on capital gain, with industrial investment the most significant element is the gap between yield and interest rates.


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