Understanding leverage – a double edged sword

Leverage is something that have made people very wealthy. In real estate, depending on the credit profile of the investor, the typical leverage is 5 to 1. If the investor has a good relationship with a bank, he/she need only place 10% down for a property, and the leverage is then 10 to 1.

When people say real estate is a good investment, I think they are confusing the leverage with the actual rate of return. Properties are not marked to market on a daily basis; there are no margin calls or calls for liquidation. Sometimes, the property assessor can evaluate the property – honestly or dishonestly –  for future investments. What other business can you hold an adjustable rate mortgage for 5 years, pay 10% and control a multi-million dollar property?

Life is good in the real estate market.

On the other hand, financial investments are marked daily; volatility is tracked for risk management purposes; and the margin – or leverage – allowed by the bank is only 2 to 1. There are opportunities in the stock market, but on an individual stock basis. Concentrating assets in a few stocks, with a margin account, can reap profits; but, there are risks.

Can you guess the type of leverage a hedge fund manager uses?

Depending on their relationship with the bank, the leverage can be extremely high; perhaps up to 50 to 1 or higher. For every million dollars the hedge fund manager places with his/her prime broker, the hedge fund can control up to 50 to 100 million in assets. To make matters worse, hedge funds will charge a 2 percent annual fee to manage your money, and take 20 percent on profits they make.

 

Leverage is a double edged sword; be careful when swinging it.

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *