How the Wealthy Get Wealthier – “Positive Leverage”

Positive leverage is a term used in the world of investing that describes the use of borrowed funds to amplify returns. While leverage can also amplify losses, positive leverage is specifically used to describe situations where the use of leverage has a positive impact on investment returns.

In the stock market a common way to use positive leverage is through margin accounts. A margin account is a brokerage account that allows investors to borrow money to purchase securities. Typically, investors can borrow up to 50% of the purchase price of securities in their margin account. This means that an investor with $10,000 in cash could potentially purchase $20,000 worth of securities by borrowing an additional $10,000 from their broker.

In my opinion, a better way to use positive leverage is in the real estate asset class. Let’s say you buy a piece of property for $1,000,000 you will generally need to come up with $250,000 and borrow from a lender the other $750,000. So now you are in control of a $1M asset for $250,000 out of your pocket. I like this!

The benefit of using positive leverage in this way is that if the value of the real estate increases, the investor's return on investment is amplified.

For example, if the investor purchases a $1,000,000 real estate deal with 25% down that returns 10%, the investor's return on investment would be 40%. $100,000/$250,000 = 40%. Great Job! You are compounding light years faster than most investors, and doubling your money every 1.8 years (40/72 = 1.8).

The main reason I don’t like margin accounts to buy equities is because of the highly volatile nature of the equities market and margin accounts usually are not fixed rate debt like real estate.

So while you can definitely lose money in real estate and achieve negative returns, it generally won’t happen overnight, like the stock market, and hopefully you’ve locked in fix rate debt so that your borrowed money cost isn’t increasing. Now you have time to decide whether your investment in real estate loss is systemic over the long term or just a temporary condition, and you have the time to make a rational decision. In the stock market a 10% crash can happen in a single day!

Most of the wealthy have figured out what I call “The Spread” : Return of invested capital vs. the cost of capital. This is how you create serious wealth. If you are able to borrow at 4% and find an investment that returns 10%, you are paid 6% on the borrowed capital. So if you can figure out how to do this responsibly, kick Dave Ramsey to the curb and take on as much fixed rate cheap debt as they will lend to you. 

Ok, I realize Dave is talking to people with credit card debt, so yeah, there is nothing good about high interest rate debt; pay that off every month! But if you have a mortgage interest rate at 2.75% which most of us do who refinanced in the last couple years, NEVER pay that off. You are getting paid to borrow money! LOVE IT! Even if you invest in zero risk U.S. Treasuries making a dismal 5% you are still making a 5% - 2.75% = 2.25% spread on your capital.

I am with the Robert Kiyosaki camp on debt. Use debt as a amplifier of return when the cost of capital (money) is cheap, assets are reasonably priced, and lever up all of your investments. When the cost of capital becomes expensive relative to the return on investment, lever down, and take on less debt. Pretty simple, right?

“One of the things you will find – which is interesting and people don’t thing of it enough – with most businesses and with most individuals, is that life tends to snap you at your weakest link. The two biggest weak links in my experience: I’ve seen people fail because of liquor and leverage – leverage being borrowed money.”

-Warren Buffet

While positive leverage can be a powerful tool for investors, it is important to use it wisely. Investors should only use positive leverage when they have a strong understanding of the risks involved and when they have a clear plan for managing those risks. It is also important to remember that leverage amplifies both gains and losses, so investors should be prepared to accept the potential for greater losses as well as greater gains.

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Best,

Derek

Derek Petersen

Chief Compounding Officer

Aviara Capital Investments