Winning at the Money Game
The world’s wealthiest people know how to win at the money game. They have figured out a way to gain leverage with their time, resources, and assets. Leverage is accomplished when you use a small amount of assets to control a greater amount of assets.
This could be accomplished through:
- Borrowing capital to increase the rate of return on your investments
- Using a variety of financial instruments or borrowing capital (i.e. margin) to potentially increase the rate of return on your investments.
- Purchasing commodity contracts that allow you the ability to control large amounts of a commodity with a comparatively small amount of capital.
- Using option contracts that allow you the ability to control large amounts of a company stock or ETF with a comparatively small amount of capital.
- Borrowing funds to finance a percentage of the cost of an investment (i.e. real estate mortgage).
- On and on…
Leverage is simply the use of O.P.M. (not the drug) but rather other people’s money! By applying other people’s money this often reduces the time needed to build wealth because of the compounding effect. Don’t get me wrong. Being overly leverage can lead to financial ruin, but when applied correctly it can be one of the fastest ways to amass a fortune.
Now let’s say you have a $1,000,000 sitting in the bank and you want to generate income. Let’s say there is a property that costs a $ million and will produce $10,000 a month of rental income. That investment would yield $120,000 a year or 12% (not including any upkeep, taxes, or other associated costs). You could take the million dollars out of the bank, buy the property free and clear, and then collect your $120,000 a year for as long as you have renters willing to pay the rent.
But what if instead of buying one property, you put 20% down on 5 separate million-dollar properties with the same income potential? What would this look like? Let’s assume you have to pay 5% to finance the remaining 80% of the property. Here is what the picture would look like using simple math:
- Property: $5,000,000 (five $1million properties)
- Income: $600,000 ($120,000 x 5 renters)
- Borrowing Expenses: $200,000 (800,000 x 5 x 5% interest)
- Profit (before expenses): $400,000 (40% yield)
So through leverage you have been able to boost your potential yield from 12% with one property to 40% with 5 properties using the same million dollars you had in the bank. This is known as leverage or using OPM (other people’s or the bank’s money) to build wealth more quickly.
Now you may say this is far too risky. There is a lot that can go wrong. However, when leverage is used properly and you have sufficient assets and a solid strategy to back up your purchases (for when things don’t go according to plan), it can be a powerful tool to enhance your rate of return. The ultra rich have figured ways to work smarter rather than harder. They do this through leverage!
So how can you apply this lesson in a lower risk fashion?
For those who don’t want to take this risk for themselves, but still want to benefit from the strategies being used by the ultra rich, you can look for a company using leverage efficiently. One example is American Capital Agency Corporation (NASDAQ: AGNC). They are a mortgage REIT (real estate investment trust). They use leverage by borrowing large pools of money at short-term rates and then buying longer-term real estate debt that is paying a much higher rate of return. This is very similar to what the Federal Reserve is currently doing with “Operation Twist”.
A mortgage REIT like American Capital does not invest in hard assets. Instead, they take out short-term loans to buy mortgage-linked securities. Their profits stem from the difference between the long-term interest rates of the bonds and the short-term interest rates paid on the loans. They are currently paying a 14.4% dividend because they are required by law to pass through 90% of their income to investors.
With recent data showing some signs of life in the U.S. real estate market, American Capital Agency Corporation could be a great play for the yield hungry investor. Of course there are risks to a mortgage REIT like American Capital such as:
- Interest rate risk: As rates go up, American Capital’s profit margins would shrink
- Default risk: If people don’t pay their mortgages, American Capital could see their profits decline.
The good news is that the Fed has indicated they are committed at keeping interest rates at rock through 2014 so this should help with the interest rate. Additionally, American Capital only invests in securities that are backed by the U.S. government so this should help to minimize the default risk.
Agency Capitals’ investment strategy is designed to:
- Build an investment portfolio consisting of agency securities that seeks to generate attractive risk-adjusted returns
- Capitalize on discrepancies in the relative valuations in the agency securities market
- Manage financing, interest and prepayment rate risks
- Provide regular quarterly distributions to our stockholders
- Qualify as a REIT
The housing market is beginning to see a recovery. Last week, we saw housing starts for new U.S. homes surge to a three-year high while homebuilder confidence jumped to its highest level in nearly 10 years! So why not get in with a company poised to explode with the uptick? Agency Capitals’ last quarterly profits were $641 million (more than 4 times that of the previous quarter). This stock is just heating up and could see even better days ahead!
Disclosure: Faith-Based Investor is long shares of AGNC. Please do your own research. This is not a solicitation to purchase or sell securities.