The Leverage Equation Page 7

  Futures contracts are legal agreements to buy or sell a commodity or financial instrument at a specified time in the future. They are standardized in both quantity and quality of the commodity to facilitate trading of these contracts on a futures exchange.

  The key point is: they are just contractual rights to buy and sell, as opposed to actually buying or selling the underlying commodity itself. This introduces leverage according to the terms of the contract, because the price change in the commodity is controlled by a tiny fraction of the amount of money (margin) that would be required to buy or sell the commodity itself. The contractual obligation is what introduces the leverage, as explained in the earlier example regarding sugar futures.

  Options are similar, except the holder has the right, but not the obligation, to buy or sell the underlying asset at expiration. The futures contract holder is obligated to fulfill the terms of the contract; whereas the option holder literally has the option to exercise his right if his contract is “in the money,” meaning the physical price has moved beyond the option strike price. If the option is out of the money at the expiration date, then it expires worthless.

  The nuances of leveraged financial contracts create highly specialized investment strategies that require great skill to implement successfully. It’s a specialized investment field that should only be accessed if you have proper training and experience. Many claim to sell futures and options courses for beginning investors, but playing with leveraged financial contracts is like playing with fire. The complexity is great enough to burn even experts, and several books would be required to fully explain how they work. They’re a highly specialized field of investing that is beyond the scope of this book, which is focused on how to apply leverage to grow your wealth.

  What is relevant here is to understand that contractual financial leverage follows the same key principles as discussed in debt leverage above. It cuts both ways by magnifying both the gains and the losses. The difference is, it doesn’t require money out of pocket because it’s a contractual obligation, not a debt that must be repaid.

  HOW OPERATING LEVERAGE MULTIPLIES YOUR PROFITS (AND LOSSES!)

  Another form of financial leverage is operating leverage resulting from the cost structure and capital structure of a business.

  The cost structure of your business is composed of both fixed and marginal costs. Fixed costs are those costs that don’t change when output and sales vary. Variable costs are those costs that change with different levels of output and sales. For example, rent is usually a fixed cost and materials are usually a variable cost.

  The higher your fixed costs as a percent of your total cost of goods sold, the higher your breakeven point, which increases both operating leverage and risk. High fixed costs and low variable costs give the greatest operating leverage, resulting in the greatest percentage change in profits, both upward and downward, for any given change in sales volume. A high percentage of fixed costs will magnify the impact of changes in revenue on total profit, which then is multiplied out in equity because the value of any asset is the discounted present value of its cash flow.

  In the stock market, you’ll see this during economic downturns where companies that experience a small percentage decline in sales will have dramatically reduced profit margins and earnings because the small decline is magnified through operating leverage. For example, a company might require 80% of its sales volume just to support fixed costs, so that all profit comes from the last 20% of sales. That means a 10% drop in sales could reduce profits by a whopping 50%, which might cut the value of the company in half (or worse, depending on market conditions).

  ArcelorMittal (symbol MT) is a great example of this problem. Revenues declined by only 15% over a three-year period, but income declined from a positive $2.3 billion to a loss of $2.5 billion over the same time period. This shows how operating leverage can cause disproportionate changes in earnings relative to changes in sales.

  What you should notice is how fixed costs increase risk and potential reward, just like other forms of financial leverage. Decreasing fixed costs, thus reducing operating leverage so that costs better match revenue, both reduces risk and potential reward from changes in income. When all costs are variable, the input/output relationship to changes in income is essentially one-to-one. However, the existence of fixed costs amplifies the input/output relationship to greater than one, resulting in operating leverage.

  For example, when I bought apartment buildings in the Midwest, the operating leverage was phenomenal compared to the much-more-expensive West Coast. Two-bedroom apartments that rented for $450 per month had fixed operating costs of $300 per month and sold for around 18K to 22K per door because that’s all the $150 in leftover income per month could support in mortgage financing.

  When the rent for those apartments rose to the $600 to $650 per month range, the value of the building roughly doubled. The fixed expenses for operation remained at $300 per month per unit, but now there was twice as much income left over to support the mortgage payment, causing the building to double in value even though the rents increased by only 30%.

  That is an example of operating leverage built into the financial statement of how apartment valuation works. When fixed operating costs equal close to rental value, it means the property is essentially worthless. However, small changes in rental income above fixed operating costs have a magnified impact on property value because of the high operating leverage.

  Contrast this high leverage situation with a theoretical San Francisco property that might rent for $2,500 per month and cost a similar $300 per month to operate. The $2,200 per month of leftover income after fixed expenses means there’s a lot of revenue to pay the mortgage, which explains why San Francisco property is so expensive. However, when rents rise by the same $200 per month, the increase in property value will only be roughly 10% (because $200 is roughly 10% of the $2,200 in income after expenses). In other words, there’s very little operating leverage in this situation.

  This is a simplified example to demonstrate the principle. Of course, no real estate market prices assets exactly this way, but they do follow the principle as demonstrated.

  Commodity stocks are another example of operating leverage causing disproportionately large swings in equity. Gold stocks routinely swing 2X to 3X the price change in gold. If gold is up 1%, the gold stock indexes might be up 2% to 3%. That’s because the price of gold might be $1500 per ounce but the cost of production for the miner might be $1200. So a $150 move in the price of gold is only a 10% price change, but it equals a 50% increase in profit per ounce for the mining company because of the operating leverage relative to changes in the price of gold.

  THE SIMPLE WAY TO BECOME A MILLIONAIRE USING FINANCIAL LEVERAGE

  Most Americans correlate wealth with becoming a millionaire. We can probably thank Rich Uncle Pennybags, the Monopoly mascot, for some of this aspiration. If making a million dollars is your goal, let’s look at two strategies for achieving millionaire status.

  The first strategy has some major flaws, but it’s also the traditional financial plan of saving your way to riches.

  First, you have to earn the money. Then, you pay taxes on that money. Then, you pay your expenses, and hopefully have a little bit left over to save. With that little bit left over, you invest it to grow. While it’s growing, you are paying taxes on that growth. It’s a long, slow process with limited growth because of strict mathematical rules.

  An alternative but well-proven strategy to become a millionaire is to just borrow a million dollars and invest that money in an asset that produces enough income to pay off the debt. When the debt is paid off, you’ll still have the asset and presto, you’re a millionaire.

  This strategy has several advantages. You immediately begin compounding your wealth on a million-dollar base of positive cash flow assets, such as real estate or business, that then pay the debt back for you. It acts like a forced savings plan where every monthly payment grows equity, plus y
ou benefit from compound growth on a much larger asset base.

  It doesn’t take a math genius to know that 10% on a million dollar asset you leveraged with debt financing grows equity a lot faster than a 10% return on the $5,000 you were able to save from earned income.

  The key concept is: you’re immediately working from a much larger base of invested capital, but always remember that this only works if the asset is cash flow neutral or positive. That’s one of the three rules governing financial leverage – the asset purchased with the borrowed money must return more than the cost of the financing.

  It might be an apartment building where the tenants pay the mortgage, or it might be machinery that multiplies revenue for your business, but the asset you leveraged must produce cash flow sufficient to pay the debt back because that’s what creates the forced savings plan and allows the compound asset growth to be the gravy on top.

  The key principles behind why this strategy works are:

  You’re compounding wealth on a much larger base of assets because of leverage through borrowed money.

  You’re attaching the investment to a business operation, whether that’s a rental housing business or some other business, so there’s a source of income to pay the debt.

  Your equity rises as the value of the asset increases and the debt is paid off.

  You also get tax advantages, assuming the interest expense is deductible against income and the asset can be depreciated.

  The McDonald’s corporation is a classic example of this strategy. Most people think McDonald’s is in the hamburger business, but they’re really in the real estate business. Hamburgers are just how they pay the mortgage (debt financing leverage). McDonald’s occupies some of the most valuable retail real estate locations throughout the world, all paid for by selling fast food.

  Corporate bond financing is another example of the same strategy where debt is incurred (financial leverage) to fund the equity growth of the business. As long as the assets created with the debt financing return more than the cost of the debt, the result is accelerated equity growth. The key is: The return on investment must exceed the cost of capital.

  There are many strategies you can use to leverage borrowed wealth into a personal windfall. Just rethink the generic platitudes and try something new. When analyzing the opportunities, manage your risk exposure carefully and make sure your income creates equity above and beyond the initial investment!

  10 MORE WAYS TO GROW YOUR WEALTH WITH FINANCIAL LEVERAGE

  If you’re not ready to apply the “borrow a million dollars” strategy, there are still many other ways for you to put financial leverage to work in your wealth plan. Consider the following potential strategies to see if any might help you achieve your current wealth goals faster or more reliably:

  Lend money, but get a percent of equity in return, not just interest.

  Buy instead of rent. Rather than rent office space for your business, buy the office space yourself. Use mortgage financing, and have the business pay enough rent to cover the mortgage.

  Buy stock on margin.

  Trade commodity futures.

  Buy commodity mining companies, instead of the underlying commodity, to capture the operating leverage.

  Refinance the equity out of your home so you can reinvest that equity in additional income-producing real estate. Aim to control more real estate for the same amount of equity.

  Refinance your home so you can redeploy the equity for investment in a business. (Warning: this increases your risk profile dramatically, so this is not a recommendation. It’s just an idea to consider.)

  Buy an investment property using mortgage financing, or find a private lender.

  Build a network of money partners to finance future real estate purchases.

  Lend money to other real estate investors who have more time and skill to negotiate and manage the deals than you do.

  Just to be clear, I’m not recommending that you use any of these strategies because many will not be appropriate for your personal situation. This is just a list of potential ideas to consider and to help get your brain thinking about how you could apply various concepts to your own wealth plan. Each is an example of increasing financial leverage to increase potential return, but always remember that they increase risk at the same time.

  For the complete list of 101+ Leverage Hacks: A Cheat Sheet for Quickly Implementing Leverage in Your Wealth Plan, go to https://financialmentor.com/free-stuff/leverage-book.‎

  THE ZEN OF FINANCIAL LEVERAGE: RISK MANAGEMENT

  Finally, no discussion of financial leverage is complete without emphasizing the importance of risk management.

  Financial leverage both increases potential rewards and decreases the odds of survivability. A highly leveraged business using debt financing has a higher risk of failure than an unleveraged business built on equity alone because the debt must be paid like a fixed cost, effectively creating a form of operating leverage.

  Stated another way, the higher the percentage of revenue that flows to profit, or conversely, the lower percentage of revenue that must pay expenses, both marginal and fixed, the safer the business and the lower your risk as an owner.

  This is intuitively obvious in the rental real estate business when you own the property free and clear. Your risk of failure is very close to zero because your remaining costs – taxes, insurance, and maintenance – should be a tiny fraction of your rental income. That makes it a very secure way to produce positive cash flow.

  The same principles apply to your personal finances. For example, if you have a big mortgage on your home and you have car payments every month because you leveraged up with borrowed money, that means you must earn that much more income to service all that debt before you have anything left over to buy food or fund savings.

  Conversely, it’s easy to pay your bills and save money when you have no housing costs and no debt. Financial freedom is easier and more secure when your cash flow requirements are lower.

  That’s why you often see people pay off all their debt as they approach retirement. It increases the reliability of their financial outcome. They’re focused on minimizing risk of failure, not maximizing wealth growth, so financial leverage is inappropriate.

  DON’T MIX FINANCIAL LEVERAGE WITH VOLATILITY

  Another smart rule is to never mix financial leverage with volatile assets because when you’re leveraged you have less ability to endure a setback.

  For example, conventional fixed rate mortgage financing is generally considered safe in all but extreme cases because real estate is historically not a volatile asset. The rental income stream is reliable enough to support reasonable mortgage financing.

  However, you want to avoid high leverage situations when the income stream is volatile. For example, cyclical industries like airlines are highly sensitive to the business cycle because people will spend for vacation air travel in good economic times but stay closer to home when money is tight. This creates volatile earnings which are a dangerous combination with financial leverage because the debt must be repaid regardless of the economic cycle. You want a consistent and reliable cash flow stream to cover the interest payments if you’re going to apply leverage to ramp up the equity growth.

  Don’t get greedy and overleverage. Make sure you’re sufficiently capitalized to survive through normal economic setbacks by building a cash cushion. Never leverage yourself enough to put survivability in jeopardy.

  IN SUMMARY

  In summary, financial leverage is a valuable tool for your wealth plan because it eliminates any excuse for money being an obstacle to financial growth. However, you’ll want to apply the following risk management guidelines so you don’t get into trouble.

  Don’t over-leverage because the best plans will still experience temporary setbacks, at a minimum. Sometimes worse.

  Always have an exit strategy to remove leverage and preserve equity so you’re prepared with clear action steps should adversity strike.

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sp; Only leverage assets that provide positive cash flow net of debt service and expenses.

  Avoid using financial leverage when the income stream supporting the assets is volatile.

  Financial leverage is most appropriate when your goal is maximum wealth growth but is inappropriate when your goal is security and stability.

  Avoid financial leverage in deflationary economic environments.

  Financial leverage used wisely can make you rich. If you apply this tool with skill and careful risk management, it can produce extraordinary results. However, it can cause a financial disaster when applied incorrectly. It’s like pouring gasoline on a fire. It will turbo-charge results, but it can also turn a little problem into a big problem fast. It’s the only form of leverage that cuts both ways, so be careful.

  If you’d like to learn more about risk management and how to apply it to leverage you can take the companion mini-course Risk Management: How To Make More By Losing Less (https://financialmentor.com/educational-products/risk-management-course).

  EXERCISE: FINANCIAL LEVERAGE IN REAL ESTATE

  Here’s a quick exercise, using three different scenarios, that will deepen your understanding of how financial leverage magnifies both investment return and risk.

  Assume you invest in a $200,000 property with mortgage interest rates at 7%, and a 5% annual property value appreciation rate.

  In the first scenario, you pay cash for the property so you own it free and clear. Using the compound interest calculator here – https://financialmentor.com/calculator/monthly-compound-interest-calculator – you’ll see that the property is worth roughly $542,000 in 20 years, resulting in a compound return on investment of 5%.

  In the second scenario, you apply financial leverage using a traditional 30-year fixed rate, fully amortizing mortgage of $180,000 with a 10% down-payment. Using the mortgage calculator with amortization schedule (found at https://financialmentor.com/calculator/mortgage-payment-calculator-amortization-schedule), after 20 years of payments your remaining balance would be $103,000 with a loan balance reduction of $77,000. That means your equity in the house is roughly $440,000 on your initial investment of $20,000. Even after subtracting the discounted present value of your payment stream of $1,197.54 for 20 years, the remaining equity represents a much higher return on investment than in scenario 1 because of the financial leverage.