The beauty – and beast – of leverage<\/p>\n
Analysis by Dianne Maley<\/p>\n
November 10, 1989<\/p>\n
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Ever wonder how the rich get rich?<\/p>\n
Well, to start with, they usually have some money. But to turn a little
\nbit of money into a lot, you have to follow religiously the golden rule of
\ninvesting: borrow in boom times and retrench when things begin to slow.
\n The magic tool is leverage. Real estate investors know it well. In times
\nof rising house prices, you buy a property with a little of your own money and
\na lot from the bank. Say you put $10,000 down on a $100,000 house; the rest
\nyou finance by taking out a mortgage on the property.
\n Over the course of the following year, the house price rises by 10 percent
\nto $110,000 — not an unreasonable thing in a healthy market. You have made a
\n100 percent return on your money in one year.
\n In a really hot market, house prices can rise even faster, making the
\nreturns stunning. This is the beauty of leverage.
\n As we have learned from the U.S. takeover binge, leverage is not limited to
\nreal estate. When a big corporate raider wants to take over a company, he
\nborrows against the assets of the target company to pay for it. Then he pays
\nthe debt back with its earnings or by selling some or all of its assets.
\n This is known as a leveraged buyout, in which little of the purchase price
\ncomes from the buyer’s pocket. The buying companies have made so much money
\ndoing this in the past while that they have lost interest in the stock market.
\nWhy buy stocks when you can buy the underlying company, break it up, sell the
\nparts and make a huge profit?
\n But when you are starting up a company, leverage may not be the best tool.
\nOften, the start-up period turns out to be longer than you expected and the
\ncosts higher. If you are relying solely on your bankers, you run the risk of
\nhaving them pull the rug out from under you before you have had a chance to
\nget going.
\n If you have an established business and you want to expand, though,
\nleverage can work nicely. You can borrow against your existing plants to
\nbuild a new one, for example.
\n By and large, small investors have learned the leverage game well. Where
\nthey go wrong is in not knowing when it is time to reverse the strategy.
\nDelightful as it is on the way up, leverage works in reverse on the way down.
\nYour holdings can collapse like dominoes.
\n To use leverage with the family home is downright reckless.
\n The problem is to recognize when the tide has turned. Is your business
\nabout to boom or bust? One clue is interest rates. When the difference
\nbetween what you are paying to borrow money and the inflation rate begins to
\nwiden, it may be time to retrench. A spread of more than five percentage
\npoints is a warning sign.
\n Currently, the real or inflation-adjusted cost of borrowing money ranges
\nupward from six percentage points, high by historical standards. The path to
\nriches is littered with the bleached bones of investors who did not heed this
\nsign.
\n Often, people overextend themselves so that when the time comes to lower
\ntheir debt load, they have no money left with which to do so. This points to
\nanother investment rule: what if? Smart investors always ask themselves, what
\nif real estate prices fall by 20 percent rather than rise? What if oil prices
\nplunge? What if the stock market crashes?
\n To use leverage properly, you have to have assets in reserve so you can
\nreduce your debt before it reduces you — to insolvency.<\/p>\n
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