How Leverage Creates Wealth
If the goal is the build wealth through property purchasing, then surely purchasing more property at an earlier point in time gives the investor the greatest opportunity to take advantage of capital growth.
Most of the Big 4 banks will provide commercial property rates at the lowest rates in the market. In exchange for these lower rates they will ask for a higher deposit to be paid on purchase (usually 35%, but sometimes 30%) and will ask for the loan to be repaid over a term of 15 years.
The alternative to request a smaller deposit amount be paid on the purchase of say 25% instead of the traditional 35%. This can be achieved with either the major banks or with alternative financial institutions.
How does this help? Simple really, a lower deposit requirement means more surplus cash to allow you to buy more property.
Let’s look at a practical example.
Assume that an investor wants to buy a commercial property for $800,000. For our purposes I am going to ignore the costs involved and focus on the deposit required by different financial organisations. I’ve also assumed the investor is using equity in other property for their deposits – not cash. Here is a summary of the situation:
Traditional Bank Financing
|Deposit – 35%||$280,000|
|Deposit – 25%||$200,000|
|Surplus CASH AVAILABLE||$80,000|
Having an extra $80,000 allows for the purchase of another investment property at a purchase price of $300,000 (25% is $75,000) and it follows that an investor can effectively buy $1,100,000 worth of commercial property today instead of $800,000 worth of property.
On the following pages you will see an example of how using leverage (a technique to multiply outcomes) can improve the level of returns on the same amount of money.
Example of Returns
Buying One Property at $800,000
Traditional Financing at 35% Deposit $280,000
|Rental Return @ 9% for 5 years||$72,000|
|Cost at 7.85%||$62,800|
|Net Return – Income vs Finance Cost Only||$9,200 (A) per annum x 5 Years = $46,000|
|Value of Property after 5 years of 7% Capital Growth||$1,122,000|
|Original Purchase Price||$800,000|
|Growth Return||$322,000 (B)|
|Total Return – Growth plus Net Rental||$368,000 (A) + (B)|
Buying Two Properties totalling $1,100,000 using 25% Deposit $275,000
|Rental Return @ 9% for 5 years||$99,000|
|Cost at 7.85%||$97,350|
|Net Return – Income to Finance Only||$ 12,650 (A) per annum x 5 Years $63,250|
|Value of Property after 5 years of 7% Capital Growth||$1,605,250|
|Original Purchase Price||$1,100,000|
|Growth Return||$ 442,000 (B)|
|Total Return – Growth plus Net Rental||$ 505,250 (A) + (B)|
|Net Difference In Return||$ 137,250|
By utilising a 25% deposit instead of a 35% deposit, this investor has improved their return on capital by $137,250 over 4 years. This is an annual return of 24% on their employed capital.