Debt

Let’s talk about debt. I was born in a communist country. My parents, like people in many parts of the world, in many countries and cultures, were afraid of debt their entire lives. Afraid of being in debt. Debt was always a bad sign, a sign you could not afford to otherwise pay for your life, and something you had to pay back as soon as possible — quickly quickly. Debt is a two edged sword — it can be the downfall for many people, but it is also the source of a lot of the wealth on this planet. You just need to understand it. Since we are all already aware of the problems with debt, I will focus here on the positive aspects of it.

Before we talk about debt, we need to talk about leverage. This is one of the most important concepts for you to understand for your investing life, and your professional life beyond that.

Let’s say you have an investment that you know will deliver 20% for you this year.

You have 1000 USD you can invest.

You invest 1000USD. This is called your “invested capital.” It’s the part of the total investment that is your own invested money.

Your return will be 200USD (20% of 1000USD that you invested)

At the end of the year you will have 1200 (1000 invested capital + 20% return from your investment).

This is called investing without leverage: you invest only the money that you have.

But let’s redo this:

Let’s say you have an investment that you know will deliver 20% for you this year.

You have 1000 USD you can invest.

You decide to borrow 1000USD from your friend or your bank, for a year. They will ask you for 1% annual interest to lend you this money.

You invest 1000USD that you have (your invested capital), plus 1000USD that you borrowed from your bank for a total of 2000USD.

Your return will be 400USD (20% of the total 2000USD that you invested)

At the end of the year you will have 2400 (2000 you invested + 20% return from your investment).

You will pay back your 1000USD to your friend or bank, plus the 1% interest of 10USD (so 1000USD plus 10 USD which is the interest rate).

You will have left 390USD, which is your return (instead of the 200USD in the example above).

This is the principle of investing with leverage.

In the first example, without leverage, your return was 200USD. In the second example, with leverage, your return was 390USD, almost double.

Why am I discussing this here? Because we almost all use it in our daily lives. We just don’t conceptualize it, think about it, properly.

Every person on this planet who buys a house by borrowing money from the bank, uses leverage to make that real estate investment. In many cities on this planet the local real estate market has grown much more quickly over the past 20–30 years, than annual interest rates from banks. In Paris for example real estate has grown at 10% per year, while banks were lending money to buy flats, for 1–2% per year maximum. This calculation was working just like the example we did above. People borrowed money to buy flats they could not afford otherwise, they paid their banks 2–3% per year in interest, and kept for themselves the 10% per year profits/capital appreciation that their flats earned. This is literally the main source of middle class wealth in many countries — people receiving debt/leverage from local banks in order to buy local real estate which they otherwise could never buy, which then appreciates in value over the years.

As I am writing this, I just spoke with a friend in Paris yesterday, who is a partner in a financial firm.

He bought a flat for 400.000 euros in Paris 4 years ago. A lovely little place in the historical heart of Paris, Le Marais, also my favorite neighborhood — a must see next time you go to Paris. He only put a down payment of 40.000euros for this. The bank gave him the other 360.000 euros. Now four years later, due to real estate prices increasing, he sold his flat for 40% more than he bought it, or 560.000euros. He therefore made a 160.000 euros profit in 4 years. Could he have made 160.000 euros with only his capital of 40.000 euros? Of course not. But by borrowing, by adding leverage, he could make 160.000 euros on the 400.000 euros he was able to invest in total. And since his own invested capital was only 40.000 euros, he literally made a 400% return in 4 years on the money he had and invested himself: he quadrupled this money in 4 years with this investment.

This might seem counterintuitive. You might think that’s not how you think, it feels wrong right? The flat made a 40% return. But this is not how investors think. Investors think about the return on their invested capital, which in this case was 40.000euros. Four years ago he had 40.000 euros on his bank account, now he has 160.000 euros. This is all that matters. The flat came and went. It could have been a collectible car, or a Rolex watch, or a whatever other object. It’s not about this — investments come and go. This is about your capital and how you invest it, and how your total assets grow over time.

You know there are many famous private wealth banks out there: UBS, Credit Suisse, JP Morgan, Julius Baer, Lombard Odier, EFG. Their clients typically keep at least 1m dollars, but often up to several hundred million dollars, with these banks. And you know what one of the main services they provide to their wealthy customers is? Lending them money for the things they want to buy. Providing them leverage. You know why? Because although their clients are wealthy successful people, although they can easily buy everything they want with their own money, they want to use leverage in their acquisitions, in their investments, in their lives. This is how they can make even more money, exactly as in the calculation we saw above.

Do you know why all professional investors work with investment banks, or prime brokers, such as Goldman Sachs, Morgan Stanley, Deutsche Bank? One of the main reasons is this exact same one: these banks lend them money for their investment strategies. Many times investment strategies deliver a “small” return, for example 5% per year. But by borrowing money from these banks, an investment manager can double their returns on their invested capital, from 5% per year to 10% per year for example. Just like in our example above.

There is another part of the investment industry, called “Private Equity.” These are the people buying large companies, improving them (or not), and selling them 5 to 10 years later for (hopefully) more money. Sure, they improve companies. But you know their real secret? Leverage. They never buy a company with money upfront, they always borrow a lot of money, to buy a company, up to 90% of the money needed actually. This way, if they improve a company by 5% and sell it in 5 years, they will make a much higher return on their own invested capital, than just 5% (in the example above, they will make 10 times more actually given that 90% was debt from banks).

Why am I talking about this here? Because I want you to not be afraid of smart debt. Debt is a powerful tool that can fuel your wealth creation. We all use it in our daily lives, typically when we buy houses. Or when we start a personal business with a loan. And I want you to understand that this is a powerful concept that can be applied to most of your professional life.

The fundamental rules of investing:

Before you become a master of leverage, there are some fundamental rules to learn, and live by. These rules are inspired from corporate finance. When the CEOs of the largest companies in the world borrow money to invest in their companies, these are the rules they live by.

1. Make sure the expected return on your investment is higher than your cost of debt

Check what your cost of debt is. Have an idea of this. First, do you have access to capital? Is someone going to lend you money? If yes, how much?

Next, if you want to borrow 10.000USD, or 100.000 or 1.000.000USD, what is the interest at which you can borrow this? What is your cost of debt? 1% per year? 10% per year?

Can you borrow money, how much can you borrow, and how much would it cost you to borrow this?

Why do you need to know this?

Because the first rule of capital allocation is that your expected return from your investment needs to be higher than the cost of debt. What do I mean by this?

If you expect real estate in your city to grow at 5% a year, and the bank is willing to lend you money at 2%, then this is an investment you can consider making. If you expect real estate to grow at 5% a year, but the bank wants to charge you 10% a year to lend you money, then your cost of debt is higher than your expected returns. The investment does not make sense.

Make sure you can match your the cash flows you owe to your lenders, to the cash flows you expect to have

Let’s say you want to borrow money and buy a house to let — you buy the house and rent it out. What are the risks to you?

1. The flat loses its value

The problem here is that if the flat loses in value (versus how much you owe the bank), then you will be in a situation where you cannot sell the flat to pay back your loan entirely.

If the flat’s value is higher than what you owe your bank, you are perfectly safe. At worst you can always sell the flat, pay back the loan, maybe even pocket a profit, and that’s all there is to it.

2. What matters most though is not the value of your flat is you sell it versus how much you owe your bank. The most important is your ability to pay, monthly typically, the monthly repayment for your loan, to your bank. In theory it doesn’t matter if the value of the flat goes up or down, as long as you can make your monthly payments to your bank for the loan. Then you’re safe right? Right. And those monthly payments will come from the rent you will collect typically, minus expenses (taxes, repairs…), and maybe a little bit from your other income if that’s not enough to pay the loan monthly. Basically you need to make sure these cash flows that you have/receive, are higher than the cash flows going out (loan repayment). In finance we say you need to match your (incoming and outgoing) cash flows. What is the risk here? Simple, that at some point your expected incoming cash flows decrease (the rents go down, you lose your salary, you can’t find new renters for several months), and are lower than your outgoing cash flows (mortgage you need to pay to your bank, taxes, required repairs).

What lessons should we draw from here?

1. If you use debt/leverage, you should favor assets with a very stable (or growing) value and stable (or growing) cash flows. You should avoid assets with volatile value that can go down a lot, and you should avoid making investments with highly uncertain cash flows, if you need those cash flows to service your debt.

In my opinion, unless you know what you are doing, never borrow for highly speculative investments whose value or especially cash flows, can vary widely. This is what happens to traders who trade on margin (they borrow money to invest a lot more than they have themselves) or with leveraged instruments like options (in both cases you effectively borrow or end up borrowing money from your broker in order to buy financial instruments) — the value of stocks can go up and down a lot from one day to the next, these people cannot match their payments to their brokers, and they end up losing everything.

2. Make sure that you can match your outgoing cash flows, with incoming cash flows over the lifetime of the investment. It doesn’t matter how you come up with your incoming cash flows (rent, rent + a supplement from your stable salary, rent + part of your savings where needed), as long as you can meet your outgoing payments.

But what about student debt? I come from a continent where university education is free or quasi free. But we all read about “the mountain of debt” that American students are burdened with. In the framework we learnt above, student debt is entirely understandable. This is how to think about it — if you go to a top university/degree, you will be highly employable and your expected cash flows — your salary/income, is therefore highly predictable. And this is why students who borrow money, get in debt, to go to such courses, not only don’t regret it, but actively embrace the opportunity that debt (leverage) gave them. The problem arises when students get into debt to go to universities or a degree with low employability and low salaries, and expected incoming cash flows (salary) are unpredictable. These students, after they graduate, sometimes end up with higher outgoing cash flows (paying back their student debt), than incoming cash flows (salary). At this point problems start, they need to refinance their student debt at a higher rate, and a vicious spiral of debt ensues. You don’t believe me? Think about it like this — in the US medical school is an entire new 4 year university course, after your initial 4 year university course. And it is a very expensive one at that — your medical school and living costs can easily cost you 300–350.000 US dollars. And this is after you already paid 200.000 US dollars for your first university course, before medical school. I never met a US doctor who doesn’t wish he/she didn’t have student debt, medical school were free. But, the employability of doctors is very high, their incoming cash flows (salaries) in the US are also high, and therefore medical student debt is not a national problem, like student debt in general is. See, it makes sense to borrow money, to get leverage, to invest in a medical school education. You know your expected incoming cash flows will match your outgoing cash flows, your debt will be repaid after a number of years, and your investment in a medical school education will earn you high returns over your career. However, getting into debt to pursue a degree with low employability and cash flows that will not, or might not, match your debt repayments after you graduate, is not an investment worth making for many. If you are already in this situation, you need to work on increasing your expected incoming cash flows — many students realize their current passion/degree won’t provide them with this, so they take an extra course in computer science/programming/website design, to do exactly this: increase their employability and expected incoming cash flows (salary/consulting work).

To be clear, I think university education should be affordable for everyone. And the truth is that the US has a wide network of community colleges, scholarships, and other low cost education options.