Focusing on absolute returns in addition to rate of return
Have you ever considered borrowing money to invest? Let’s pretend that you’ve invested $75,000 cash in a real estate investment that yields an annual 15% cash return. Let us assume you hold the investment for 10 years and the property value grows by 20%. On an absolute basis, your $75,000 investment would now be worth $90,000 with total cash receipts of $112,500. This investment would have an Internal Rate Of Return (IRR) of 15.9%, outperforming the average 10-year S&P return of 13.9%*. This is a great rate of return! However, the absolute return (i.e. the total value created) could have been much higher with a larger initial investment.
*S&P return sourced from NCREIF first quarter 2021 indices review document
Leveraging up: borrowing money to increase investments
Not everyone will have access to large amounts of cash for big investments.
Do not dip into emergency funds for illiquid investments. That money should be A) liquid at all times and B) accessible at all times.
Instead, you could consider borrowing money to invest (at a reasonable lending rate) to increase your total investment. With the right interest rate spread and cash flow model, the resulting cash returns on the investment could easily service monthly interest payments. The equity / capital growth will be larger than if you had just used cash on-hand, increasing your overall return. The biggest benefit is that the absolute return is ultimately much higher than in the first scenario.
Borrowing money to invest is a tactic used by corporations, private equity firms and hedge funds all the time – and the same principles can apply to consumers making big investments.
Cash flow model scenario for borrowing money
When borrowing to invest, it’s important to look at the numbers – particularly your cash-flow model:
- Image a $300,000 real estate investment that expects to produce an annual cash return of 14%.
- You invest $225,000 cash and then borrow the remaining $75,000 at a rate of 7% with a 10-year maturity.
- The monthly payment (Principal + Interest) against the loan stands at approximately $871 per month.
- Assuming a cash return of 14%, the $300,000 investment would generate cash inflow of $3,500 per month. The monthly cash inflow will not only help you to service the interest payment but also help to prepay the loan at an enhanced rate.
In this scenario, the cash returns more than compensate for the monthly payments. Plus, they could help you to prepay the loan in less than 2 years (as shown above).
As seen in chart 2, a $300,000 investment with estimated cash returns of 14% will help you to get your entire initial investment back in just 7 years after paying-off the debt (9 years from initial investment – Month 108 in Chart 2 above) and this duration reduces with higher cash return as shown in Chart 2. Cash inflow post the break-even period is just surplus cash for you to invest in other opportunities. Such debt is often called “smart debt,” financing appreciating assets, unlike “bad debt” that people borrow to “consume” such as paying for vacations or luxury cars.
“Smart debt” considerations: borrowing money the smart way
In our example, the risk-reward equation is so attractive that you only need a minimum annual cash return of just 4-5% to at least service the monthly payments while having some margin surplus on the investment.
However, while the idea looks attractive on paper, this investment strategy is not for everyone. We propose a few rules-of-thumb for investors who intend to consider this avenue:
- Investments come with a risk. Do your research and be prepared for uncontrollable factors which may put your entire investment at risk. Be sure you can cover your monthly payments even if the target investment doesn’t pan out.
- Better to not borrow for short-term trading or gambling bets as the payback is not structured.
- Operate with a “margin of safety”, investing at a price lower than your estimated entry value. A good “margin of safety” increases your comfort and safety level.
Where can physicians borrow money at a decent rate?
There are several options available for financing investments such as these:
- Banks and credit unions offer standard lending options though the time to funding could be frustrating depending on membership status, paperwork, approvals or home assessments.
- Credit cards are another option to access quick cash, but the cash advance charges are typically very large and would likely wipe out expected returns.
- A quicker and viable option available specifically for doctors would be Doc2Doc Lending’s loans for physicians. You can get your rate within a day and most borrowers have the ability to deploy their capital within days of applying.
Doc2Doc Lending provides qualified physicians with personal loans up to $75,000 at physician-preferred rates often lower than our big bank competitors. If you are interested, apply for one of our physician loans in less than 3 minutes in order to the rate for which you qualify. It won’t affect your credit score and this way you can start to calculate just how much money you stand to ultimately earn with your investments!
Note: This strategy is not for everyone. We recommend that borrowers talk with a qualified financial professional to discuss.