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How to increase the rate of return on your investment

by Greg Carroll www.attitudefinance.com

 

While there are numerous variables that can affect the performance of an investment the most important lesson to learn is that performance is very much guided by a set of rules or laws, if you like. And once you understand how these laws play a part in the performance of your investments the more effective your investment strategy and your results will be.

 

Probably the most easily understood law is the law of compound interest. Historically, Australian property values grow at an average rate of 7-10% per annum. Therefore property values in Australia tend to double every 7-10 years. Let's look at a simple example to illustrate.

 

We buy a property for $250,000. The 10 year average growth rate is 7%. The table illustrates the price growth over 10 years.

 

Year

Value ($)

Start

250,000

Year 1

267,500

Year 2

286,225

Year 3

306,260

Year 4

327,699

Year 5

350,637

Year 6

375,182

Year 7

401,445

Year 8

429,546

Year 9

459,614

Year 10

491,787

Growth in value ($)

241,787

 

As you can see the property nearly doubles in price over this period. Now some years the growth might be higher than 7% and some years it may be lower or even negative. But if this is the average growth over this period then this will be the result.   

 

The second law to understand is the power of leverage. Leverage is the principal of using a small amount of effort to create a significantly larger result. In the case of investment it is using a small amount of your own cash to amplify your investment returns.

 

For example we purchase a property for $200,000. We fund the purchase with $40,000 of our own cash and borrow the remaining $160,000. Through leverage we have been able to acquire a higher value asset than would have been possible using just our own funds. Leverage is measured as the percentage of the amount borrowed against the value of the asset. In this case 80%. This percentage also reflects our level of risk. The higher this percentage the higher our level of risk.

 

Again for most of us this concept is fairly straight forward but many may not be aware how their level of leverage can actually affect the performance of their investment.

 

Let's assume we have two investors who are each given $40,000 to invest in property. They can purchase to whatever value they like but have to borrow the balance of the purchase costs. The interest rate for borrowing is 8%. No matter what price they purchase at, their property will receive a 4% per annum rental return and 8% per annum capital growth in the first year.

 

Investor 1 decided to purchase a $150,000 property and Investor 2 purchased a $400,000 property. The table below shows the results.

 

 

 

Investor 1

Investor 2

Purchase price

$150,000

$400,000

Purchase costs

$5,700

$16,000

Cash Investment

$40,000

$40,000

Debt

$115,700

$376,000

Leverage

77%

94%

 

 

 

Rental return @ 4%

$6,000

$16,000

Net growth @ 8%

$12,000

$32,000

LESS Interest @ 8%

($9,256)

($30,080)

Net gain

$8,744

$17,920

Rate of return on initial $40,000 invested

21.86%

44.80%

 

Based on the above scenario Investor 2 has more than doubled the performance of Investor 1. Now certainly Investor 2's risk is greater. In fact 22% greater than Investor 1. But what is more interesting is that for a 22% greater risk he has increased his performance by 104%.

 

This is the real power of leverage. Understanding that small changes can have significant results.

 

The learning from this is how you structure your finance will have a significant bearing on the overall performance of your investment. 

 

 

This information is provided in good faith but is not intended to be comprehensive and does not constitute advice. The above information is an example only and does not take into account market fluctuations or individuals specific circumstances. The ability to access the rates or repayments shown is dependent on individual circumstances and specific lenders policies. Attitude Finance accepts no responsibility or liability for anyone relying on this information.

 

    MTA Finance
    1917 Logan Road
    Upper Mount Gravatt Q 4122

    T 07 3849 9822
    www.mtafinance.com

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