How to Use Other People's Money to Invest

Posted by Ed McKnight on 25/03/20
Investing with Other Peoples Money
Introduction

What Should I Invest In?

You may already be convinced that you need to build your wealth, whether because you want to achieve your aspirational goals or because you want to prepare for retirement. The question then turns to ... "what's the best way to build my assets?"

The truth is, there are so many different ways you could invest and grow your money. Here, at Opes Partners, we only deal in property investment because it is an efficient way to grow your existing money using the power of leverage.

How does this work?

In this article we are going to clearly explain the three different types of leverage, so you can determine whether you're able to use this concept to grow your wealth.

Potential Returns

What Return Can You Get From Different Types of Investments?

Go to most seminars or read a standard investing book and you'll see a graph like this:

Different Types of Investment

There are four different asset types you can usually invest in:

  • Cash
  • Bonds and Mutual Funds
  • Property
  • Shares

Investing your money in 'cash' like term deposits is the lowest risk and also attracts the lowest return on investment.

The current 12-month term deposit rate at ASB is 2.55% for investments over $10,000. There's very little risk, but at 2.55% and CPI inflation at 1.5% currently, there is very little return on your investment.

Next are bonds and mutual funds. Depending on your mutual bond you might get a return of 4%. There's more risk than leaving your money in the bank, but slightly higher return.

Then you've got property. Property isn't the highest returning asset class as a percentage, earning around 5-6% per year, but we'll come back to this.

You've got a little more risk with property than you do in cash or bonds, but not as much as in our final category – shares.

Shares tend to get a 9-10% return over time, but they come with significantly more risk than any of the other asset classes.

So you might be wondering –

Leveraging the Bank's Money

How can property make me more money if shares have a higher return?

Property is the most efficient use of your money as an asset class for one very important reason – leverage. In fact there are three types of leverage you can use in property investment. Let's walk through each type.

Leveraging Your Deposit

Say you invest in a $500,000 property. You wouldn't actually put in $500,000 yourself. You'd only put in the deposit.

For a brand new property that would be $100,000 and the bank would lend you the other $400,000.

But, as the property goes up in value, you don't get the return on the 20% deposit you put in. Instead, you get a 5% return on the full $500,000 property.

You may have heard the saying that to build wealth you need to use "other people's money".

This is what they mean.

You put in 20% of the purchase price and get a return on the full purchase price, while you've used other people's money (the bank's) to fund the investment.

So how does this change how well property performs compared to these other asset classes?

Well, if you invest $100,000 in cash at 3% year on year, in 15 years you'll have $160,470.64. So you made $60,470.64

If you took the same $100,000 and put it into bonds at 4%, in the same 15 years you'd have made $87,298.12.

Now, let's talk about shares. Given that they get the highest percentage return at around 10%, by the end of 15 years you would have made $359,497.30, which you'd no doubt be pretty happy with.

But, even though property gets a lower percentage return (at around 5%), because you're able to invest $500,000 by using $400,000 of the banks money, after 15 years you would have made $591,437.29. That's 65% more than shares and 9.78x more than leaving your money with the bank.

This is why the first type of leverage is so important. You don't just get a return on your own money, but on the banks money as well.

Leveraging Your Own Equity

But what If I don't have $100,000 to invest in property?

The above example might sound compelling, but what if you don't have $100,000 to invest.

Many Kiwis don't, so how do so many people still get started with investment property?

This is where the second type of leverage comes in – using the equity in your own home to fund the deposit for your investment property.

Over the last 5 years, the median house price in New Zealand increased from $454,000 to $629,000 (Dec 2014 - Dec 2019). That's $175,000!

That means that the median homeowner now has an additional $175,000 worth of equity within their home.

You can use some, but not all of this equity, to help fund the deposit for your investment property.

Let's say that you bought the median house in December 2014, and used a 20% deposit. That means you started out with a mortgage of $363,200.

Under the Reserve Bank's lending restrictions you can borrow up to 80% of the value of your home. Because your property is now worth $629,000, that means you can increase your borrowing up to a maximum of $503,200.

But, remember you've still got that mortgage, of $363.2K.

So once you take that away from the maximum amount you can borrow, there is still borrow $140,000 against your own property.

That might sound scary taking out another mortgage, but the repayments on this mortgage will be covered by the tenant of your rental property (more about that in the third type of leverage), and your total 'net worth' will be exactly the same in the end.

Now that you can take an extra $140,000 out against your own home, you can use that money as your deposit to invest.

If you were to buy a brand new property, you only need a 20% deposit for your investment. This means that you can now buy a $700,000 investment property.

That's why you don't need to have a lot of cash to get started in investment property – you can use the second type of leverage to fund your deposit.

Leveraging Tenant's Rent

So how do I cover the repayments for mortgages?

If you've had a mortgage for a while, you know how important it is to keep up with your mortgage repayments. And some potential investors can get worried when we talk about taking on more debt.

It's important to remember that you're only taking on this debt to get ahead financially, and that the vast majority (if not all) of your mortgage repayments will be handled by the third type of leverage.

When you purchase an investment property it goes without saying that you'll rent the place out to a tenant.

That tenant will pay you rent each week, which you'll then use to pay for your mortgage, rates, insurance, property manager, maintenance, accounting, and any other expenses you have.

If you do use the second type of leverage, where you purchase an investment property with 100% lending, your mortgage repayments will be higher than if you'd use a deposit.

That often means that your third type of leverage (rent) won't fully cover all your expenses, so you may need to top up your property by $50 a week or so.

However, remember the key reason you've invested in property is to get that 5% growth on $500,000 we talked about earlier.

Conclusion

An Example of Using All 3 Types of Leverage

Say you buy a $500,000 property that you top up by $50 a week because you've bought it using the second type of leverage.

If your property goes up at 5% in the first year, you will have made $25,000 in total, but only put in $2,600 worth of cash ... you've made a 962% return.

In other words you put in $50 a week, but capital growth gave you $480 a week.

This is why property is such an efficient way to build your wealth:

  • You can use the bank's money to earn a return on an asset worth 5x more than your deposit
  • You can use the equity in your own home to fund the deposit if you don't have one
  • You can use your tenant’s rent to pay for the majority of the costs of owning the property

These types of leverage can't be matched by the other asset classes in terms of their efficiency of building wealth, which is what makes property so unique.