Debt Eats Equity

The heading of this article is not original to me; it came from Stuart Nattrass, probably during those conversations around the board table. As a long-term board member of South Canterbury Finance, he would know about debt on both the upside and the downside.

The dynamics of debt

What he meant is that when the economy is tough, returns are falling, and interest rates are rising, which usually results in asset values falling and debt compounds until it has eaten all the equity. Then, in effect, the debt owns the asset, and the owner is wiped out or worse.

The first major mistake people make with debt and, for that matter, with investment selection is the assumption that “debt always enhances return”. 

Debt simply increases risk, thus the opportunity for return and the probability and possibility of loss. When you buy an asset outright, you are taking a risk on its quality and future returns. In addition to these risks, you take on the risk of market momentum to a much greater degree when you take on debt. Then, with respect to the asset you acquired, you inherit the risk of becoming a price taker on the downside.

This often manifests itself when people talk about property investment and how rewarding it is, how it outperforms every asset class, etc. The BBQ talks focus on how smart everyone is and quote ‘leveraged’ rather than ‘unleveraged’ returns. 

To illustrate

Assume in this case 4% rental return on purchase price, and 8% interest rates and 50% gearing.

How often do you hear boasts around the BBQ, such as “I am making 40% plus on property”? How often are the cash losses from over-gearing ignored as an investment and simply thought about as a tax break? This is confirmation of bias, delusional analysis, and self-justification thinking that occurs around geared investments.

So tell me, what is the true rate of return on this property on the upside as a gain? And the true loss on the downside on a fall? And what is the impact of gearing on these returns?

Let’s say we purchased the property, and on day one, it was making $4,000 in rent. The ungeared income return is 4% if it goes up by 20%, simply put, your return is 24.8%. If it goes down 20% on the slide, your loss is 16.8% (20%-3.2% income).

Debt is a trade between capital growth and interest rates.

For a day-one cost of $4,000 in interest, you were placing a bet on midterm growth of 4% or more. In short, an option for growth.

In a sense, this is not one investment but two investments. So, on the upside, your property return is 24.8% on $50,000 (being the growth of $20,000 plus the rent of $4800, divided by two $12,400). On the debt investment, you paid away $3,200 in interest and made $12,400, i.e. a net of $9,200. So, in this instance, your return on borrowing is 287%!

Of course, one year is a short cycle of investing. The other issue with debt is if your equity is reduced, you run the risk of having your loan called. If the loan is called and the asset is sold out from underneath you, you don’t have a long-term.

Debt is a bet on long-run momentum; if you get it wrong in the short term, you lose.

The second major mistake with debt is the assumption that the terms of debt are constant. They are not. We do our cash flows on the structure of a deal and say, “Look, the cash flow from the investment will pay the interest with a margin”. Well, it does until it doesn’t. If the income falls, you’ll have a cash flow negative and without a line of sight as to where you will get cash, you quickly run out of it and head into default, and presto – no long-term for you as the asset owner, and now the debt holder owns it.

My own story is that in October 1987, I bought a house for $130k (just before the 1987 stock market crash). I rented it, yes, and believe this, at $20k pa. I borrowed the lot at 25% and fixed it for three years as the variable rate was 29%. I thought that was the smart thing to do. The loss was manageable at $12,500 pa. By 1989, the rent had halved, and the value had dropped by $30,000.

Fortunately, the bank didn’t panic at the negative equity because I had income to service it. But $22,500 was a lot harder than $12,500. Never forget that each marginal dollar creates more pain on the downside than the dollar in front of it. As you accumulate more, each dollar you earn has less impact on your life.

I still own that property, and the long-run ungeared returns on it are 8.5%, tax-paid. That’s not bad, but nothing to boast about. In absolute dollars, 40 years of compounding turns into a decent sum.

I have said this in other contexts: You only get long-term returns if you survive, and you won’t survive if you run out of cash.

Golden rule… never run out of cash.

To close on one final thought on debt, debt is fixed with time, but on the downside, if you get wiped out, you must start again, and you are losing time. If you are wiped out, accept it and start again if you are young enough. Holding on for ten years is ten years less time you have to recover.