One big advantage real estate investors have over stock market investors is the use of leverage. Of course, we all know debt is a double-edged sword, but for the most part, using it works out. Assets tend to go up in value, at least most of the time. Say you were going to buy a $300,000 rental property. For just $30,000 out of your pocket and an agreeable lender, you’d get it. Sure, you’d also owe a whole bunch of debt with it, but it would be yours to rent out, hopefully at a higher rate than the mortgage payment and other…
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One big advantage real estate investors have over stock market investors is the use of leverage. Of course, we all know debt is a double-edged sword, but for the most part, using it works out. Assets tend to go up in value, at least most of the time.
Say you were going to buy a $300,000 rental property. For just $30,000 out of your pocket and an agreeable lender, you’d get it. Sure, you’d also owe a whole bunch of debt with it, but it would be yours to rent out, hopefully at a higher rate than the mortgage payment and other expenses.
People buy stocks all the time using debt, but can never get the type of leverage real estate investors get to enjoy. After decades of stock market crashes right when people were feeling the most bullish, margin providers have clearly learned their lesson. Letting somebody control $10 of a stock for $1 isn’t a good idea.
Many investors don’t bother with margin debt, instead choosing to use a line of credit secured against property as a way to borrow. These days, that’ll set an investor back 3% annually, which is easily covered by a lot of large, blue-chip company dividends.
Canadian Oil Sands Ltd
It’s easy to see why investors would want to own Canadian Oil Sands. It has a rock-solid position in the best oil field on the continent. Its reserve life is greater than 35 years. As long as the world’s oil price doesn’t crater, the company should deliver consistent production and dividends. Currently, shares yield 6.04%.
Assume an investor wanted to put $10,000 into the company. Instead, the investor uses leverage and borrows an additional $10,000 at 3%, upping the total investment to $20,000. Considering how Canadian Oil Sands is a low-growth company, let’s assume 4% capital appreciation over time and no increases to the dividend.
After five years, a $10,000 investment would be worth $12,166. In the same time, investors would have received $3,020 in dividends. The total return would be 8.71% annually.
If an investor borrowed an additional $10,000 to supercharge their returns, they’d receive an additional $5,086 and pay a maximum of $1,500 extra in interest, assuming a 3% rate. That’s also assuming the investor didn’t pay back a nickel in principal.
After five years, the return on the original $10,000 would be 86.7% once interest has been deducted. That ups the annual return to 13.1%.
TransAlta has had some pretty widely known problems over the last little while, culminating with a dividend cut earlier this year. It appears to be turning the corner though, taking steps like raising capital, spinning off its renewable power assets, and indicating to investors that poor results in its U.S. coal power generation division will return to normal. The company easily earns enough to cover its new 5.6% dividend.
Instead of going through the numbers again, let’s assume an investor uses their dividends solely to pay down the debt. How quickly could a $20,000 investment pay off a $10,000 loan?
Assuming an investor just used TransAlta’s dividends towards paying off the debt, it would get paid off in a little over 11 years.
The effective return on the original $10,000 investment would be 11.2%, less 3% interest. That’s without a dividend increase or appreciation in the share price, looking at pretty much the worst case scenario.
There are many advantages to using leverage to enhance your investment returns, especially for high-yielding stocks. Real estate investors have had this advantage for years, so look at it as leveling the playing field. Adding a little more risk can do wonders for your returns, as long as you’re diligent in paying off debt.
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Fool contributor Nelson Smith has no position in any stocks mentioned.