Leverage is one of those financial words that gets thrown around a lot that most people don’t really seem to understand. People say things like “I’m over leveraged” or “leveraged to the hilt”. We more commonly understand physical leverage such as a teeter-totter or using a stick and a fulcrum point we understand how to physically move things. We talk about “leveraging our relationships” or contacts or followers.
To illustrate the point of financial leverage it helps to go through a story. So let’s say we want to pool our money together and buy a business as an investment. This is done all the time by private equity firms and the example is the same. We call all of our family and friends and combined we get $2 Million of cash (also called Equity, so Private Equity is just a fancy name for people’s money) to work with.
In a non-leveraged world, if you have $2M, then you can buy a business worth $2M. But using leverage, the story changes dramatically. Similar to how physical leverage multiplies your effort, financial leverage can multiply your returns, or your losses if it goes that way. The amount of leverage you can apply will depend on many factors, but typically a 5/1 ratio is standard. At 5/1, that means that instead of looking for a business worth $2M, we can look for a business worth $10M to purchase.
Normally, established businesses are purchased for the cash flow of earnings and a business owner is paid a multiple of earnings. The multiple depends on the industry and the business, contracts with customers and growth potential, but lets say in the in this case that we are buying a pest control company that handles mostly industrial buildings, has long term contracts and based on other offers we have to pay 10 times earnings for Best Pest Control Company.
We use all of our money to make the down payment of $2M and we get a loan from the bank for the other $8M we need to buy Best Pest for $10M. For the next 10 years we run the business, and just to make this an easy, apples to apples discussion, we have the exact same profits every year. Each year Best Pest makes $1M before our extra interest payment on the money we borrowed from the bank. The bank also requires we make payments on the loan but not necessarily over 10 years. Just as with your home, sometimes the loan periods are longer. Typically for business loans, such as commercial buildings, the loan will only be good for 10 years, but the payment schedule looks like a 20 year loan and then there is a balloon payment (fancy word for pay what is still owed on the loan) at the end of the 10 years. This is because banks don’t know what will happen to interest rates so they don’t get locked in for longer periods. Home loans are one of the few financial products with a 30 year fixed rate.
When we buy Best Pest, the amount that we pay for the future profits, or the non-physical assets of the business, is called goodwill. If Best Pest has a lot of assets, such as service trucks, a business office location with improvements and inventory of pest control products, then part of the payment for the business would be for those assets and the rest would be considered goodwill. Regardless of the form, the entire expense paid for the business is a deduction for us, the form just determines how quickly we can take the deductions. In this case we will say that all of the business is goodwill, just to make it simple. Goodwill is deducted over 15 years, so we get to deduct 1/15 of the $10M each year.
Because we already paid for the business, the Goodwill deduction is just a reduction of tax, we don’t have to pay for it again and that leads to free cash flow. The one extra expense that we do have to pay that the prior owner did not is the interest expense. Interest expense is based on the rate, so if we can get a 4% business loan we can calculate the payments and amount of interest expense. To do this we use an Amortization Schedule.
To calculate how much money we will make we take our earnings, pay the interest, deduct the goodwill and that leaves very no or very little taxable income so we only pay a little in taxes and the rest is left for us owners to take as distributions. And don’t forget we didn’t pay again for the goodwill deduction, so our math for how much cash is left is Year 1:
Profits: $1,000,000
Minus:
Interest (474,190)
Taxes
Payment on the Loan
Plus:
Goodwill
Equals = free cash flow.
This may look strange as you wouldn’t think that a business that technically has a Loss of $140,000 is paying out over $341,000 to its shareholders, but that’s exactly how this works. The company will have a book loss until year 10 and would pay little in taxes until year 16 when the deduction for Goodwill is zero.
So, each year, immediately after purchase, the business is returning over 15% to all of us who invested our money. This alone would be a great return, but remember, now we own the business. Let’s say 10 years later we decide to sell the business and to continue keeping the analysis simple, we say the sales price is the same as our original purchase price. But we have paid off a large part of the loan, so after we get $10M, we repay the loan. We return the original amount everyone gave us and we are left with an additional $2.8M of gains – known as long term capital gains (more than 1 year = long term, capital is just money, and gains is profits).
Now we distribute that money to our group and on the whole, everyone has now averaged a 30% return on their money. That is an outstanding return that anyone would be happy to get, all courtesy of leverage. When we look at that, it seems great, why wouldn’t we do that all the time, and to juice the returns up even better, why don’t we put even less down??
Well, so far we have only discussed the good side of leverage, what about the bad side of leverage. We should take another look at Best Pest to see how the leverage scenario can go wrong. The assumptions are that Best Pest continues to make the same profits, every year. Now an optimistic person will say that you should be able to grow the business and maybe they are right, but what if you just bought at the wrong time? What if Best Pest is a franchise and when you purchased Best Pest you had the only franchise license in the area, but either Best Pest sold another franchise license, or a new competitor saw your large profits and decided to open up in the same neighborhood. Large profits usually result in additional competition and preferences, technology and other things can change the fortunes of any business.
Now if Best Pest had never sold, then there would just be fewer profits but it could continue to do business with lower profits. But, because as new owners we have to make loan and interest payments, if the profits go down then there is lower return, and then at a point, the cash flow becomes negative. When cash flow becomes negative, instead of giving a return, we would all need to put more money into the business. Is everyone willing to do that? We can see different scenarios, but when profits drop by about 33%, there is negative cash flow. At this point we decide to sell the business and we are going to owe more to the bank than the business is now worth, potentially wiping out all of the original money we invested. The bank may lose in this situation as well, not getting back the total amount that it lent to us.
This also means the business will now be worth less money when we try to sell it. Lets say after 5 years we sell the business and profits have dropped year over year. After 5 years, the business is only worth half and maybe less as no one likes to pay a premium when profits are falling. If the value drops enough, then we don’t get any of our original money out.
This is easily illustrated in stock purchases. Many accounts are allowed to trade on margin, which is a fancy way of saying you can leverage your money. Typically leverage is not allowed at more than 5/1 – or 20%. If you wanted to buy $10,000 worth of stocks, that means you would only need $2,000 in cash. If the stock price goes up to $12,000, then instead of making the 20% return if you had paid all cash for the investment, you would make 100% profit. But if the stock price goes down 20%, you will lose all of your investment. Margin trading is risky, but rewarding when the bet goes the right way for you. Because of this high risk, the SEC limits margin on stock accounts to 2/1 – or 50%. So you would need at least $5,000 to buy the $10,000 worth of stocks. Currency and other trades have different margin requirements.
We can apply the same type of analysis to a home purchase. If we assume that the cost for us to buy a home will be the same long-term cost as it would be to rent, then the analysis is very similar. Home purchases and leverage include a couple of other considerations, specifically the Private Mortgage Insurance (PMI) requirement if we put less than 20% down, so we can look at some different purchase scenarios for different down payment amounts and different returns based on the leverage we are able to deploy.
First time home buyers are likely the only people in the country who are allowed to leverage themselves at 33 times with a 3% down purchase option. Because of the high risk, these borrowers are required to purchase PMI and that cost is determined by the amount put down and your credit score. Typically the PMI goes away once the loan balance is less than 80% of the home value. This can come from making payments on the loan and from appreciation. If this is just from making the monthly payment, then it will take about 9 years before the PMI is no longer required without appreciation or additional payments to principal.
In order to make this a simple analysis, we do the same thing we did with the business, buy a home and sell in in 10 years for the same price. The main factors in how much is made is the PMI cost and how much difference that makes in terms of what you would pay for a mortgage versus paying to rent. As we understand this relationship more, it can help us make informed financial decisions for a home purchase.
You can play with the worksheet to adjust the Down payment amount, the interest rate and all the other boxes in yellow, including what would alternative rent cost and what will be the PMI expense. Depending on your credit, any or all of these things could change, but if you think you’re going to be better off just because you are paying a mortgage instead of paying rent, that may not be the case. PMI can be expensive and if lower cost rent is affordable, then you could be losing money. Leverage only works for you if you can get the right situation.
Download the worksheet here and also listen to the podcast on this here.
I’m also open to answering your questions via email! Hit me up at dave@keepyours.org.