Tuesday, July 24, 2007

Leveraged Investments: High ROI Is Not Always Best

A recent leveraged-investment discussion revealed that people can calculate a high Return on Investment (ROI) from borrowing by not counting the debt principal as a cost and (in one case) not counting the debt interest as a cost.

Consider a choice to invest $250 cash v. $250 debt:

Investing cash to earn 10% earns 10%.
Investing debt at 5% interest-cost to earn 10% earns net 5%.

However, it is common to claim that debt gives the higher ROI.

Free money, for the asking, no strings attached, no debits

Financial analysts can claim that debt gives the higher ROI by not counting the debt principal as part of the investment, yet counting the net returns from debt (your ROI sprouts from "nothing"). The argument is that the debt is "not your money," although a credit check of your name would not agree completely and at the very least the argument ignores the legal liability, risk, insurance requirements, effect on credit score, credit score's effect on other loan rates, etc.

Infinite ROI, infinite profits

Excluding the debt principal from the initial value of an investment certainly can raise the apparent ROI. However, that argument suggests that 0% downpayment gives you infinite ROI when we all know that, for any given dollar amount of investment, you would be poorer by borrowing more of it and richer by borrowing less of it (as in the "Consider a choice" above, and the example below).

Wait, there is no such thing as a free lunch after all

While a high ROI seems efficient, at some point you want to maximize your profits in dollars rather than percentage points. You cannot buy lunch with percentage points. You need dollars.

Look at your real estate profits here in Net Operating Income (NOI):

$250,000 [100%] paid in full in cash:
--$26,400 in rents - $3300 expense = $23,100 NOI
--$23,100 / $250,000 = 9.2% ROI

$25,000 [10%] cash down payment [plus $225,000 mortgage]:
--$18,879 in mortgage payments + $3300 expense = $22,179
--$26,400 in rents - $22,179 = $4221 NOI
--$4221 / $25,000 cash in front = 16.9% ROI

example from: Using Financing for Real Estate Leverage

The NOI trend gives you an idea of your hard-earned money that you keep by putting a larger downpayment on your mortgage (although this is a rental example).

These types of examples are very common to extol leveraging but you can see the trend that the more you pump up the ROI, the less money you make.

Cocktail-party bragging rights to the higher but leveraged ROI will cost you $18,879.

How high an ROI do you want?

(PS: The NOI informs you that the leveraged ROI is inflated because it ignores that you left $225k cash idle and (apples to apples) the actual leveraged ROI here is only 1.7% ($4221/$250k), or 0.9% ($4221/$475k) if you include the $225k mortgage to discount for debt risk.--Note added 7/25/07, last updated 7/30/07)

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Leveraging multiplies scale, volume, and risk but I will leave that for a future article. Alternate uses for the same money (opportunity costs) such as stocks or arbitrage are separate choices and each can be leveraged or not leveraged.

Next: Inflating Leveraged ROI Can Ruin You

See also:
Never Prepay Mortgage? Housing Myths Part 1
The $200,000 Blunder: Housing Myths Part 2
Home Mortgages Are Bad Investment Tools? Housing Myths Part 3
Homeowner Profits Ignore Huge Costs: Housing Myths Part 4


3 comments:

Kurt said...

Apples to apples my friend! You can't assume in one case you are committing $250k while in another you are committing $25k! The link you gave even references the fact that you'll have money to invest elsewhere. In the leveraged case, you're also paying back a portion of your mortgage, increasing your returns (not all the mortgage payment is an expense).

And for the record, you can have infinite IRR. For instance, if I agree to pay you a dollar just because you asked, the IRR of that transaction is infinite.

The argument that you need dollars, not percentages, is rubbish. If you assume that your choice is to invest in one alternative or leave the cash in your mattress, you're right: leverage is bad. However, we live in a world of nearly endless investment opportunities, and to assume that I will leave my money in cash and not find a productive home is simply false.

For instance: if I buy a house for $250k, I can use debt to pay for 80% of it and put the remaining $200k into other investments, generating percentage points (and dollars).

J at IHB and HFF said...

Kurt,

Hello and thank you for your comments, which mostly reinforce my conclusion. I was trying not to tackle too many issues at once but, yes, if the investor wants to make up that $19k that he/she missed by leveraging, he/she has to go back to work and find yet another investment for the remaining $225k to at least break even with the non-leveraged option, while (apples to apples including risk) praying that he/she does not miss a single month’s rental income because that would plummet the leveraged ROI below the non-leveraged ROI, 8.1% v. 8.4%, or miss 2 months and find that the leveraged option is bleeding -1% ROI while the non-leveraged option is a healthy +7.5%.

Thank you and please visit again.

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