Article by, Brad Bowman
Simply put, Positive Leverage occurs when an asset produces more income than the cost of money borrowed to purchase the asset.
Let’s look at an example. Suppose you invest in a building leased to Dollar General. Assume the bulding is purchased for $1 million and it produces $85,000 per year in Net Income (rent less expenses). The income represents a return of 8.5% annually based on the cost of the proeprty. If you invest 30% down payment ($300,000), you could likely obtain a loan for $700,000 at 6% interest. So, here is where the positive leverage comes in. The $700,000 you borrow costs 6%, but it is making 8.5%, which gives you a 2.5% return on money that they bank provided to you.
Another way to view this is that, with the property earning $85,000 per year and your interest cost at $42,000 per year ($700,000 @ 6% interest), your net investment return is $43,000 per year ($85,000 income less $42,000 interest). If your investment is $300,000, you would receive 14.3% annual return on investment.
If you paid cash for the property, your investment would yield 8.5%. By using Positive Leverage, your return on investment would be 14.3%. The property is the same. But, your return increases by 68%. When was the last time your investments produced a 68% greater return? Used appropriately, Positive Leverage is a powerful tool that can dramatically increase the rate of return on your investments.
Of course, this is an oversimplification. The bank loan would likely be paid as principal plus interest amortized for 20 years or more. A more accurate analysis is through Internal Rate of Return (IRR) calculations. But, the prudent investor will use Positive Leverage to supercharge the return on investment, which helps to build wealth faster.
Please don’t confuse Positive Leverage with the leverage that occurred in years past. Many investors lost some (or all) of their capital by leveraging. But, they may not have been using Positive Leverage. As with any investment, you should be aware of the risk, and only invest in programs that are appropriate to you.
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