Leverage

January 1, 2018

We got lucky.  We bought a home in the GTA 15 years ago.  We borrowed $200,000 and paid $250,000 for our small home.  The value has grown to $750,000.  Seems like a great investment but let’s look at the arithmetic.  Growth from $250,000 to $750,000 in 15 years is an average annual rate of return of 7.6%.  That is a fantastic rate for an asset that is supposed to be a slow growing, stable, boring investment.  But, did we really pay $250,000 for our home?  We have 15 years of property tax, interest, maintenance, insurance and other expenses.  Adding this to the cost base changes things.  We paid about $50,000 in property tax, $50,000 in interest, and about $30,000 in everything else.  As an imprecise calculation, we paid $380,000 in total over the 15 years equating to a 4.4% annual rate of return.  4.4% is a great annual rate of return for a home, but it isn’t 7.6%.  Traditionally speaking, a home isn’t a great investment, but it is a beautiful forced savings plan.  Every mortgage payment is partially adding to net worth.  At a 4.4% average annual rate of return, we earned a respectable return and participated in a beautiful forced savings plan.  Why do we feel fortunate?  Leverage.  We invested $50,000, paid expenses of $130,000, and had a mortgage of $200,000.  A total investment of $180,000 grew to $750,000 in 15 years.  That is an average annual rate of return of 9.98% on the $180,000 invested.  And, we have a place to live.

 

Leverage is investing borrowed money.  It seems to scare the daylights out of everyone when the asset isn’t a house.  I think there is an irrationality here. People seem to have no problem borrowing $500,000 to buy a house but think it is crazy to borrow $50,000 to invest in growth investments.  Note the $450,000 difference.  Even more confusing, many borrow another $500,000 and buy a second home and rent it out.  The rent is fully taxable, and any price appreciation is a taxable capital gain.  Plus, there is much work attracting and screening tenants, collecting rent, maintaining the property and other headaches.  Selling is time consuming and the transaction cost is high.

 

There is no doubt that throughout history growth markets have been more volatile than the single family real estate market.  The greater volatility of growth markets rationally but potentially wrongly scares people off leveraged investing.  There is also no doubt that growth markets have returned a greater after-cost rate of return than real estate markets over the long term.  I understand we need a place to live.  I don’t understand the appeal of the investment property.  I could be convinced if you are an extreme handy-man who enjoys that work…but that is about it.

 

Leveraged investing works if the after-cost rate of return is higher than the after-cost interest expense.

 

The arithmetic is simple for leverage within a TFSA.  Wealth is manufactured if the rate of return is higher than the interest rate on the borrowed money.  The opposite is also true.  You can’t write off the interest expense and you pay no tax on dividends or capital gains.  It is as simple as assessing whether you earned a greater return than the interest rate cost.

 

As an example, you borrow $50,000 and invests in a TFSA.  If the long-term average rate of return is 7% and the long-term interest rate averages 4% and you held the investment and paid interest for 30 years, your portfolio would grow to $380,612 and borrowing costs would amount to 30 years x 4% x $50,000 = $60,000.  If you did not borrow and simply invested $2,000 per year, the same amount as the annual interest payment, and earned 7%, your portfolio would grow to $188,922 after 30 years.  So, $380,612 minus the loan equals $330,612 compared to $188,922.  Not too bad!  You assumed risk.  But, you did not attract and screen anyone, you didn’t fix anything, you didn’t kick anyone out, you didn’t pay any property tax, and you didn’t have to borrow a ton of money to buy the financial assets as you would’ve with real estate.

 

The ability to borrow at a lower cost than the rate of return of growth investments is typical.  This is evident in long-term charts.

 

Leveraged investing in a non-registered account is trickier.  The interest cost is tax deductible at your marginal tax rate.  That is the good news.  For example, if the loan rate is 4% and the marginal tax rate is 30%, the after-tax cost of the loan is 2.8%.  Dividends (it makes no sense to borrow and invest in an interest paying investment) and any triggered capital gains are taxable.  Remember, dividends from Canadian corporations and capital gains receive preferred tax treatment.  Because of the preferential tax treatment, it makes sense to skew the leveraged portfolio towards Canadian equity.  From this follows that it makes sense to skew other portfolios away from Canadian equity towards safety to maintain proper asset and geographical allocations.  Or, skew the leveraged portfolio away from dividend paying investments.  If the investment does not pay dividends – or a low rate of dividend – it matters less that the borrowed money is invested in Canadian growth investments.  Smaller company ETFs fit this description such as this and this.

 

The key to leveraged investing is to borrow a reasonable amount.  Do Not Over Borrow!

 

Summary and a few facts of leveraged investing within a TFSA:

  • The lower the interest rate the better.  The best option is a secured loan on your home.  Currently (late 2017) rates are below 4% on a secured loan.

  • The interest rate is variable.  If interest rates rise, there is greater incentive to cash in the investment and pay off the loan.

  • There is little work and instant liquidity with leveraged investing in growth markets.  The online broker collects the dividends and you don’t have to hire a real estate agent and a lawyer to sell.

  • Risk is dependent on the amount borrowed.  The more borrowed, the more risk assumed.

  • You can invest in growth assets from anywhere in the world.

 

Summary and a few facts of leveraged investing within a non-registered account:

  • A portfolio with borrowed money in a non-registered account should be skewed toward Canadian equity for the preferential tax treatment of Canadian dividends.  All other accounts should be adjusted accordingly with less Canadian equity.  Or, if investing in non-Canadian equity, low or no dividend investments are preferable to a higher dividend paying rate.  Large cap. companies (big companies) pay higher dividends than small cap. companies.

  • The Vanguard or IShares broad market passively managed Canadian ETFs work well.

  • Like an investment property, interest cost is tax deductible.  The higher your marginal tax rate, the greater the deductibility.  For example, if you are in a 54% marginal tax bracket your after-tax borrowing cost on a 4% loan is 1.84%.

  • Any dividends and any triggered capital gains are taxable.  The higher your marginal tax rate, the higher the tax burden.  If you are in a 54% marginal tax bracket, dividends from Canadian corporations are taxed at 39% in Ontario.

  • You would buy and hold within a non-registered account.  Buy and hold does not trigger a capital gain.

  • You get to choose when to pay the tax on capital gains, however, all gains are triggered when the surviving spouse passes away.  You can defer for a long time, but you can’t defer forever.  Note that this can be dangerous.  Many people got hurt by Nortel in the early 2000's.  They bought shares of the company and the price went through the roof.  Some had over a 10-fold gain.  Many sold but many didn’t because they were dissuaded by the large capital gain tax bill they would trigger.  Those who didn’t sell saw their huge gain decline to a 100% loss.

Wrap up

 

How about this?  Borrow $50,000 if your net cash flow and net worth suggest it is reasonable and invest as above and hold it for 10 years.  You may have to rebalance periodically but commit to a 10-year holding period.  Let’s say you purchase the investment at the beginning of the absolute worst 10-year period and over a 10-year period your money does not grow.  0% over a 10-year period is an unprecedentedly horrible return.  You would be out $20,000 pre-tax with a 4% annual interest rate and less after interest tax deductibility.  Would this unprecedentedly horrible return change much about your life?

 

Note that if you invested in Canadian equity in May 2008, right before the big crash and the worst time to invest, you would have earned an average annual return of roughly 3% by December 2017.  That is a horrible 10-year return, but it is still positive.  And, it likely outperforms what you would’ve earned investing in risk free GICs over the same period.  Markets rise over time.  Imagine what happens if the next 10 years are not horrible.  

 

Too few take advantage of the upward sloping trajectory of markets.

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