Getting Rich by Using Other People’s Money

Today another guest post by reader Sander. He already reached FIRE and is currently enjoying his newly found time. We met a short while ago for lunch. Yes, this was one of those “let’s meet complete internet strangers for coffee” kind of thing. Sander is a smart guy, and so is his investment strategy. I like it and asked if he could write a post (or two?!) about it. He didn’t disappoint! Today we are going to look at “Getting Rich by Using Other People’s Money!”

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Getting Rich by using other People’s Money

You gotta love this title, don’t you? It’s what we do when we focus on real estate investments. We lend money for let’s say 3%, charge a rent of 5% and keep the difference as a reward. I we lend half the amount needed, this raises our ROI from the original 5% to 7%, which is a considerable raise.

When you are in real estate, this is normal. In fact, most real estate investors I know try to raise their leverage as high as possible in order to maximize their return on capital.

I’ve been investing for years, and I always found this leveraging very appealing, since it can really raise your return on investment. But, alas, I am not a real estate kinda person. The hustle of fixing things, renters not paying me, looking for new tenants, I don’t know. The returns are appealing, but the hassle sure isn’t for me.

Getting Rich by using other people's money
Getting Rich by using other people’s money

But a very big advantage of real estate investing is the leverage. Now I’m a former banker, so I know a few things about leverage and the risks associated with it.  On top of that, I am an active investor in bonds, stocks and options.

I came up with an answer how I could make use of leverage, without having to turn to real estate. It’s a bit of a long story, but the essence of what I do is easy. I will try to shed some light on it.

My goal is a portfolio which yields income, just like a real estate portfolio. I need a steady yearly income, so I can use that for living expenses.

Step 1: create a portfolio which yields income

I analyze the stock market and pick three categories for this income.

Getting Rich By Using Other People's Money - Table 1 (before leverage)
Getting Rich By Using Other People’s Money – Table 1 (before leverage)

Of course, many hours of researching, analyzing, reading etc. have gone into selecting the individual stocks within each category. I am willing to share insights with people interested, but for the sake of simplicity I will only give a hint of flavor:

  • High dividend stocks: think ING, Aegon, Amsterdam Commodities, Ahold, Royal Dutch Shell, Ishares Stoxx small 200, Ishares Euro Dividend.
  • Real estate: think Eurocommercial Properties, Vastned, Wereldhave, Realty Income, Simon Property group, Think Global Real estate.
  • High Yield: think Rabo ledencertificaten, Achmea 6% 2006 perp, ASR 5% 2014, Ishares $ high yield corp bond, Ishares JP Morgan EM local gov bond.

Choosing carefully leads to a portfolio yielding around 5%. This is nice, but I don’t think real estate lovers are excited yet about this ROI…

Step 2: Creating leverage

This is where the magic happens!

Where real estate works with very cheap mortgages, I found a way to even cheaper leverage stock market investments. In fact, the average interest I currently pay on my leverage is 0,22%. I could elaborate on the way I create this leverage, but I will also leave that for now. I will just say it’s not for everybody: you need some assets in your broker account. Let’s say around 50k. If you’re interested, leave a remark, perhaps I could write a second article about the ‘how to-part’. (Editorial Mr CF: yeah, you should! I hate cliffhangers).

If I use 100% leverage against my initial investment, I take out a loan of €500.000. The costs are €1.100 euro per year (0,22%).

With this €500k, I just double my portfolio:

Getting Rich By Using Other People's Money - Table 2 (after leverage)
Getting Rich By Using Other People’s Money – Table 2 (after leverage)

The net result is €50.000 minus €1.100 funding costs is €48.900, which is a net result of 9,8%. Now this sound attractive, doesn’t it? This sounds like an income you could live from…

Have in mind that this takes not into account the fact that the stocks in portfolio might rise, which they most probably do over time. Of course, there is also a risk of lower assets prices, which makes a good bridge to the risks associated.

Risks

Yes, of course. No pain, no gain. No risk, no return. Risks are not bad per se, but they need to be carefully analyzed and managed as good as possible. So what are the risks?

  • Stock market risk
  • Margin risk
  • Interest risk
  • Other risk

Stock market risk is the biggest risk

A bear market could really hurt, so bear in mind to pick stock with a low beta and a low drawdown to minimize the risk. Since I’m a banker, I tend to overallocated in financial institutions, because I understand them. This would, however, not be my advice to others. Boring is good. Pick Unilever, Royal Dutch Shell, Ahold.

The more leverage you use, the smaller the stock part should be. The risk of a real bear market is just too big.

Margin risk is related to stock market risk

The leverage I take out makes use of margin in my stock broker account. This means they keep an eye on the risks of my portfolio versus the value of the assets. It’s a complicated calculation which they use to calculate the risk. In fact, I also use their values to manage my risks! However, their margin calculation can indicate I need to sell stocks when the markets are down. This is of course something I want to avoid at all costs, so I keep a buffer to keep me from harm.

Keep in mind that there is also a liquidity risk here, which also effects the margin risk. In bad times, it could be difficult to sell your stuff.

Interest risk: Like I said, I was a banker…

When you take out a loan, the interest is floating or fixed for a certain period of time. This is called the duration. When you invest in bonds, they also have a duration. The more those two durations differ, the more you are open to interest risk.

For example, the duration of the Rabo Ledencertificaten is even infinite, so beware of a short loan to cover them. If the interest rises, the cost of your loan rises, while the yield of the asset is fixed, hurting your income real bad…

Other risk could be whatever

For example a policy change at your broker, changing the margin policy. This could mean you need more cover. There could also be some kind of fraud in one of the companies you are investing in, or even your broker.

Conclusion

Smart use of leverage could really boost your income. This is a common practice in real estate investing, but I would also recommend this for other ways of investing for income.

There are risks associated with it, and therefore it should only be used by people who know what they are doing. In my opinion, every investor should know the ins and outs of his investments, and even more so if there is leverage used. This goes for stocks, bonds but also for real estate investing.

I feel the reward outweighs the risks, but be aware of what you’re doing. Debts can be harmful, for all kinds of investing, also for real estate!

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24 Comments

  1. I think that I’m with a number of the other comments in that this is fascinating but it doesn’t suit my risk profile.

    This approach feels like it takes more effort than other forms of investing. Even if you invest in a Vanguard High Yield tracker you will then also have to keep an eye on the interest rate and other terms of your loan as opposed to just automatically invest and forget.

    Also leverage in this form carries more potential downside risk that I would want to live with and you really have to be in it for the long term. Unless I’ve misunderstood the way that this leverage works seems to suggest that you need to invest it all at a single point in time rather than drip feeding it in (if I wrong then I’ll join the chorus for a part 2!).

    Interestingly it makes me wonder if the FIRE community overall is actually quite risk adverse . So much of what we talk about is how becoming FI protects you against the downside. However most people don’t spend a lot of time thinking about the risks of losing a job, or not being able to pay the bills etc.

    Very interesting post though.

    1. Sander used to work in the financial industry, so has a lot of insights that he can use to manage his risks and portfolio. He’s a smart dude for sure. But I agree that this investment style is certainly not for everyone, myself included. Still, I’m fascinated by it!
      Thanks for the comment Cavemen!

  2. Too risky for me. Probably because I don’t understand it well enough. But still interesting to read it. Even if it is just to understand the principle. And who knows, maybe if keep reading this kind of posts, eventually I will gain more knowledge and dare to undertake these more complex investing strategies

      1. Now it makes some sense.

        I know some people who use options similarly to great effect.

        I’m still not sure if I’m not smart enough or just don’t have enough time to dedicate to figuring them out?!

  3. Interesting article! You may write more about it.

    But this method isn’t for me. I don’t sleep well at night with these risks.
    Paying off debts is stressful. I have more fun in increasing my investments.

    De kleine belegger

  4. Hi CF, looking into leveraging myself. Currently, I use the service my broker provides, which costs me EURIBOR (with minimum of 0%) + 1,2%. That’s a bit more than your proposed 0,22%.

    Please elaborate!

    1. Hey Bob, that’s still not a bad deal to get credit either. As noted to DI, Sander is using option spreads to acquire this low “financing” rate. I hope I can persuade him to write a detailed post about how. Thanks for reading!

      1. Would love to see the math behind these option spreads. Surprised it works out this cheap. I also understand the hesitation to explain in detail as options are bloody complex and timing has a major impact on efficacy/price. Not for beginners and not for the faint of heart.

  5. Cool stuff! Hope you are working on part two! Please don’t leave us without sharing how to create the magic. I have to agree with CF, cliffhangers suck

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