Wednesday, July 27, 2016

$17,500 Richer? The Power of Leverage...

Ah, the power of leverage.

Without it, I would argue you are in the SLOW lane of wealth creation. With it, you've got the power to literally move financial mountains! But if you aren't using leverage yet, that's OK. Read on!

Leverage is an incredible concept when you think about it, isn't it?

Webster and Investopedia define leverage differently, but I want you to notice the similarity:

Webster: the mechanical advantage or power gained by using a lever.

Investopedia: the use of various financial instruments or borrowed capital, to increase the potential return of an investment.

Notice the two action words that unite these definitions together: gain and increase.  More on this later, but remember gain and increase for now.

I wanted the picture of this article to clearly explain exactly how leverage works in an easily understandable and memorable image, and I think this one works best. So what do we see?  We see that with a little ball, when using leverage, it equates to a very large ball.  The two balls become in balance, and as a result, the little ball's mass essentially equals the big ball's mass.

Do not miss the power in this concept:  If I only have a little ball, with leverage, I can achieve the outcome EQUAL to having a very large ball. 

So let us tie that back to what we care about: investing, investment returns, growing wealth, big bucks, LARGE SUMS OF MONEY, etc!  So - how did I use leverage to earn a 100% return in one year and become $17,500 richer? Let me tell you:

Many of you know, I have several rental properties, and that I think real estate is the fastest way to growing huge sums of wealth.  Well, I am moving at a snails pace when it comes to real estate investing, doing it only as a 'forced a side-gig from the Army' moving me all of the time, and I am still seeing huge, huge advances in wealth. Stay with me.

Consider the following:

The Case-Shiller Index, if you have not heard of it, measures U.S. residential real estate prices and tracks changes in the value of residential real estate both nationally as well as in 20 metropolitan regions.  They recently released data that shows U.S. home prices rose 5.2% year-over-year from last May to this May.

Big deal, right? 5% is not that much.  HCP Inc. (HCP), a real estate trust in my portfolio is currently yielding north of 5.5% in dividends alone. So who cares? 5% is nothing to write home about.  OR IS IT?

I purchased my Colorado Rental several years ago now, towards the end of 2012 for right at about $350,000.  But I only paid $17,000 to get it.

So let's say that from when I first purchased the home until now there has been no other appreciation except the 5% that just occurred from last May to this May.  So how did my $17k investment perform? Can you figure it out?

My return, annualized from January 2013 to May 2016, on my $17,000 investment, returned 23.6% per year.  23.6% per year!

And if I consider how this investment performed just from last May to this May, my return is almost exactly 100%!

How is that possible? This is the power of leverage at work.  I took a $17,000 investment (or a little ball), and controlled $350,000 (a very large ball) with it. As a result, I experienced a very large GAIN or INCREASE on this investment.  Leverage!

The math for this problem is actually quite simple:

$350,000 * (1.05) = $367,500.

$367,500 - $350,000 = $17,500

$17,500/$17,000 =102%

Illustrated in words, a 5% increase in my home purchase price, minus the original purchase price, equals how much my investment returned, or $17,500.  A gain of $17,500 on a $17,000 investment is a little over a 100% total return.  Incredible.

This truly is the power of leverage at work and how to build real wealth.  The above picture is just another example of what I am saying.

And when you consider that the Zillow, Trulia, and USAA Home Circle price estimates of my home when averaged together are currently $395,710 you get an even more incredible return.  Perhaps Zillow or Trulia are not great as a stand-alone estimate, you may say, but all three of these estimates averaged together cannot be too, too far off.  When you consider this $395.7k estimate, now my annualized return from the purchase date until now is closer to 35% per year.

Very, very cool.  That's about all I can say.  And praise God!  Where are you going to get 35% year-after-year for 3.5 straight years? Not in equities.

So what are your thoughts?  Do you agree with the power of leverage, as shown above?  Thanks for reading!

Passive Income Dude

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