According to Investopedia. Leveraging results from using borrowed capital as a funding source when investing to expand the firm’s asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets. When one refers to a company, property or investment as “highly leveraged,” it means that item has more debt than equity.
Simply put, leveraging would be borrowing money to invest in an asset that promises to give you returns that will outweigh the cost of borrowing and thus increase the return on investment.
While the applications of this concept are wide, it is commonly used in property investments. In a basic scenario, this would mean borrowing money from the bank in order to purchase a property that you intend to rent out with the anticipation that the rental income would cover the costs of paying back the loan and possibly even make a profit.
Ordinarily, a bank would not cover the full cost of the house and would require a deposit from the person taking out the loan. This means if the cost of purchasing the property is K1000,000 then the bank would require you to put a deposit of K200,000 (for example) and they would then lend you the K800,000 at the agreed interest rate for the agreed period of time i.e 20 years.
Imagine the agreed interest rate is 20% and you are required to make payments of K4,200 every month for 20 years. This means that if you rented out this property for K5,000 a month then you would earn a monthly profit of K800 and after years would own the property outright. Given that property generally appreciates in value, assuming a simple growth rate of 5% per annum (for arguments sake) would mean that the property which was worth K1,000,000 would be worth K2,000,000.
Thus you would leveraged your initial K200,000. Even if you had the full K1,000,000 available to purchase the property outright at the beginning, it would take you over 10 years to recoup your initial capital outlay from rental income whereas your return on investment would be greater if you had opted to take the leveraged position.
As mentioned earlier, the practical applications are vast and the above example is quite a simplified scenario that does not consider the risks involved. Another application would be to use the leveraged position to diversify. Again, taking the example where you have the K1,000,000 available, rather than purchase one property out right, you could put K200,000 deposits on 5 different properties and look to further increase your return on investment while spreading your risk. We’ll look at a practical example of this scenario in the future!