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A new psychology on investing

If you are one of those investors that only talk about the Growth + Yield combination to determine the quality of an investment, today I am going to change your psychology on investments.

Let me start with a simple question: which asset is better – Asset A or B?

 Asset A  Asset B
 Asset Value  $500,000  $500,000
 Growth%  10%  12%
 Yield%  4%  6%
 Growth + Yield  $50,000 + $20,000  $60,000 + $30,000
 Net Gain  $70,000  $90,000

Most people would say Asset B is definitely better than Asset A, as it has 20% higher growth and 50% higher yield, what a silly question!

Really?  Let’s consider another factor – Leverage Capacity:

  Asset A  Asset B
 Leverage Capacity  80%  50%
 My Money  $100,000  $250,000
 Finance  $400,000  $250,000
 Interest Rate  – 7%    – 7%

After deducting interest cost:

 Asset A  Asset B
 Original Net Gain  $70,000  $90,000
 Interest Cost  – $28,000  – $17,500
 New Net Gain  $42,000   $72,500

Let’s look what investment is all about – Return On My Money:

 Asset A  Asset B
 My Money  $100,000   $250,000
 New Net Gain  $42,000  $72,500
 Return on my money  42%  29%

Let’s put Leverage, Growth, Yield together and see who calls the shots:

 Asset A  Asset B
 Growth%  10%  12%
 Yield%  4%  6%
 Leverage Capacity  80%   50%
 Return on my money  42%   29%

You see, when you put Leverage Capacity in the picture, it almost makes Growth and Yield insignificant.

A higher Leverage Capacity will not only increase the likelihood of a better return on your money, but it may also lower the risk on your investment as well.

If most lenders are only willing to lend you up to 50% of an asset, it is because (as anyone in the finance industry would tell you) the lenders are not interested in losing money.

Therefore, what they are basically telling you is that your asset can easily lose up to 50% of its value.  On the other hand, if lenders are happy to lend you up to 80%, it follows then they don’t believe that your asset can drop more than 20% in value.

Lenders don’t just dream up those leverage percentages. Together with insurance companies, they have researched enormous quantities of past data and analyzed future trends to establish those figures. They have done a lot more research than you and I can do in our spare time.

If lenders and insurance companies make a mistake on the leverage percentage, they would very quickly make changes to rectify the situation. That’s one of the reasons why a few years ago in Melbourne for example, some of the inner city apartments couldn’t get 80% finance with most lenders.

Therefore, when you need to determine whether an investment is good investment, the formula below may help:

Leverage Capacity > Growth + Yield

I have been asked, by many clients, why we don’t see newspaper articles or investment magazines mention leverage capacity when the two types of asset are compared?

My guesses are:

1) That the people writing the articles may not be from the finance industry. Hence, “they don’t know what they don’t know”. Further,

2) That the comparison would be too ridiculous to make because the asset classes that can get higher leverage will make others look quite silly.  It’s only meaningful to do a comparison if two things are comparable. Where is the fun in comparing the Melbourne Cup winner with a snoring pig?

So next time when you select an investment property, make sure your first question is:

“What percentage (LVR) can a low-doc borrower borrow against this property from most lenders?”

There are 3 key points here:
1) A Low-doc borrower is a borrower that does not have to provide income proof to the lenders.  The reason we use low-doc borrower, as part of the condition, is that the lenders realize that they can’t rely on the borrower’s income; the only thing they have to rely on is the quality of the asset.

2) We also need to make sure that it is not only one or two specialized lenders that can do this.  Unless the majority of the lenders agree with it, there is still doubt that the investment property may be at risk of losing its value during any bad times.

3) From the lender’s perspective, the higher the leverage you can get under these conditions, the better the quality of the investment property.

I would like to complete this article with a quote I like:

“Since we have problems with or without money, we might as well have money.”

Bill Zheng is founder of Investors Direct Financial Group, a leading property finance company providing financial solutions for property investors and developers. Bill is a keynote speaker at many property and finance conferences throughout Australia. www.investorsdirect.com.au



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About

Bill is founder of Investors Direct Financial Group, a leading property finance company providing financial solutions for property investors and developers. Bill is a keynote speaker at many property and finance conferences throughout Australia. Visit www.investorsdirect.com.au


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