1. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Leveraging is the use of techniques that permit investors to control or benefit from an investment with a given dollar value while using less than that given dollar value of the investor’s own money. –Permits investors to control more or larger investment assets than they could control with their own equity alone. –There are three types of leverage: Financial leverage Inherent leverage Tax leverage

2. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 What is it? Financial Leverage –The use of borrowed funds to supplement the investor’s own dollar investment (equity) to increase the scale of investment. Positive leverage –If the investment return on the asset exceeds the interest rate paid on the loan, the investor’s return on his equity will rise above the return on the underlying asset. Reverse/negative leverage –If the return on the asset is less than the interest rate paid on the loan, the investor’s return will fall below the return in the underlying asset. Investors may be able to deduct the interest expense against investment income on their tax returns –Subject to limitations

3. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 What is it? Inherent Leverage –Often referred to as financial leverage, although it involves no borrowing –Leverage inherently created by the investment asset itself. No borrowed funds are involved. Derivatives such as option contracts and futures contracts require investors to deposit only a fraction of the value of the assets underlying the contract. –If the value of the underlying asset moves the right way, the investors’ returns are potentially much greater than the return they would earn by taking a similar position directly in the underlying assets themselves, and vice versa.

4. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 What is it? Tax Leverage –Similar to the concept of financial leverage, except the money is implicitly borrowed from the government rather than from an actual lender. These implicit loans are created when the U.S. government provides tax incentives for employing various tools and techniques that allow taxpayers to defer the payment of taxes. The ability to defer the payment of tax is essentially an interest-free loan from the government. –The tax leverage involved is essentially equivalent to a subsidized or below-market discount loan rather than a fully interest-free loan. In some other cases, the amount of tax paid in the future may be less than the amount of tax originally deferred. –This is essentially equivalent to an interest-free loan where part of the debt is forgiven.

5. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 What is it? Margin requirements –Securities traded on organized exchanges or in the over-the-counter market are subject to minimum investor equity requirements, as set by the Federal Reserve Board’s Regulation T –These rules apply to the amount of equity investors must have and maintain in both securities purchased with financial leverage and those that are inherently leveraged. Apply regardless of the source of borrowing –Investors must set up a margin account. The minimum portion of the purchase price that the customer must deposit is called the initial margin and is the customer’s initial equity in the account. Investors must maintain a specified minimum level of equity relative to the market value of the investment called the maintenance margin.

6. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 How does it work? Bank example –10% equity –90% other peoples money (CDs, checking accounts, etc) Cost ranges from 0% to 7% 14% average return –Profit spread Leveraging enables an investor to purchase a larger asset than his own available funds will permit.

7. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 When is the use of this technique indicated? When the investor does not have the available cash to finance the purchase of a particular asset. When the investor can borrow money at a rate lower than the expected return on an investment –Leveraged debt should only be incurred only when the investment will earn more than the cost of borrowing When the investment itself can generate sufficient “cash flow” to cover “debt service” –The annual cost of interest and any principal payable on the debt.

8. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 When is the use of this technique indicated? When the goal of the investment is long-term appreciation rather than a current return –The investor has other available resources to cover the annual cost of debt service. During periods of high inflation. –At such times, borrowing money enables an investor to purchase an asset immediately. –The appreciation in that asset offsets the effects of inflation. –The investor can pay off the debt in the future with dollars that have been “cheapened” by the effects of inflation.

9. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Advantages Leveraging makes it possible to purchase an asset the investor might not otherwise be able to afford Leveraging may significantly increase the return on the investors equity When used to obtain depreciable property, leveraging increased the tax benefits to the investor –Depreciation may be based on the full purchase price of the asset, and not just the amount of the investor’s equity.

10. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Advantages Leveraging permits the investor to spread a limited amount of available funds throughout a number of investments –This enhanced diversification adds to the safety of principal. The creditor will have an interest in the financial soundness of the investment –In order to protect that interest, before a loan is made, most lenders will make an independent investigation of: The underlying value of the property The borrower’s ability to pay both interest and principal. –May provide the investor with an objective evaluation of the appropriateness of the venture.

11. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 Disadvantages “Reverse leverage” –The cost of servicing the debt (both interest and principal) exceeds the total return (both cash flow and appreciation) If the primary purpose of the investment is to obtain appreciation, and there is little or no current income generated, the annual debt service payment requirements may place a significant cash flow pressures on the investor.

12. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 Disadvantages Leverage automatically increases risks of an investment since the debt must be repaid –Regardless of the return the investor receives The creditor, as a “partner” in the venture, may impose certain restrictions on the investor. May restrict an individual’s ability to borrow for other purposes.

13. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 How is it implemented? Once it is determined that an investment may be appropriate for leveraging: 1.Determine the investor’s borrowing capacity –No matter how much the investor may want to borrow, prospective lenders will impose limitations on the amount they are willing to lend

14. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 How is it implemented? 2.Determine the appropriate amount of leverage, examining: The availability of future funds to meet debt service requirements. –The future funds may be derived from the cash flow of the investment of the investment itself or from outside sources such as other investments, the investor’s personal income, or other borrowed funds. The spread between the expected return on the investment and the cost to borrow –The higher the expected rate of return, the greater is the advantage of leverage (and therefore the greater the risk the investor should be willing to take). The greater the tax advantages of borrowing, the more the investor should borrow

15. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 How is it implemented? 3.Determine the alternative sources for leverage borrowing Such alternatives might include: –Bank financing »Either secured by the investment property, other personal assets, or possibly unsecured –Margin borrowing from a brokerage house »Secured by the investor’s portfolio of securities –The cash value of insurance policies –Seller financing (“purchase-money” financing) –Borrowing from friends and family

16. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 What are the tax implications? Interest paid on debt to finance investments may be tax deductible. –The deduction is subject to limitations. Interest paid on debt to finance investments (other than passive activity investments) is deductible only to the extent of net investment income. Net investment income: The excess of investment income over investment expenses associated with the investments producing the income. –Includes dividends, interest, royalties, rents, net short-term and long- term capital gains, and ordinary income gains from the sale of investment property.

17. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company17 What are the tax implications? Under the tax rules until 2010, taxpayers may include dividends and long-term capital gains qualifying for the reduced rate in the computation of their net investment income. –They must elect to forgo the reduced rate on those dividends and gains –Normally this is not a good choice. The interest expense not deductible by reason of this limitation may be carried over indefinitely and applied against net investment income in future years. –Interest expense is deductible only to the extent of investment interest income on instruments such as bonds and other categories of ordinary income.

18. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company18 What are the tax implications? Borrowing makes sense in two circumstances: –If the lending rate is less than the dividend coupon rate, this is a positive after-tax leverage position for the investor. –If the investment interest expense for the year exceeds the net investment income (computed by excluding the qualifying dividends and long-term capital gains), investors may choose to include in net investment income just so much of their qualifying dividends and long- term capital as is necessary to zero-out the investment interest expense. Another strategy is to borrow against the personal residence. –Such interest is not deductible as investment interest. –A deduction may be available for qualified residence interest.

19. Leveraging Investment Assets Chapter 42 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company19 Where can I find out more about it? Tax Facts on Investments Managing Derivative Risks: The Use and Abuse of Leverage Essentials of Real Estate Investment Keys to Investing in Real Estate Personal Financial Planning with Financial Planning Software and Worksheets