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Why Leverage In A Property Investment Is A Double-Edged Sword

18 Jul
Leverage In A Property Investment can be a risky investment, but it has it's advantages. One of my experiences in Hua Hin proves it.

Second Go In Thailand

Getting on the plane in Paris yesterday headed for Thailand where I’m spending the week to carry out some on-the-ground due diligence for a new property investment opportunity in this country, I couldn’t help but think of my last investment in Thailand more than 11 years ago.

That deal didn’t turn out as planned… which happens sometimes.

I like to say that one advantage of investing in real estate is that you can’t lose all your money.

However, that’s not 100% true. Exceptions exist… circumstances where you can, in fact, lose all or most all of your money.

The direct investment I made with a developer in Thailand 11 years ago proved to be one of those exceptions. The concept was sound… as was the developer, who had a solid track record. But the investment didn’t play or pay out as any of us involved believed it would. I’d say in hindsight that it came down to timing and bureaucracy.

The developer behind the deal was operating in Hua Hin, where he had already completed several successful projects. The local market was expanding, with more locals buying properties and also foreigners beginning to discover and settle in this beachfront city.

The property was well located, and the idea for development was simple. The developer wasputting together an investor group to buy the land. Then he would get the necessary permits and sell lots. Doesn’t get much more straightforward than that.

The developer had trouble getting the permits he needed, though. This delayed things considerably… and, meantime, the market turned.

In theory, I still own part of a corporation that owns this piece of would-be development property in Thailand. However, the developer has been incommunicado after one small payout to investors a few years ago… the money for which he raised by selling part of the land.

So, in fact, I didn’t lose all of my investment... but about 80% of it.

Putting money directly with a developer qualifies as a high-risk investment. I wouldn’t recommend it to someone just starting out investing in real estate overseas… and I wouldn’t recommend investing money this way that you can’t afford to lose. You have no control over how things play out, and you have little recourse if things don’t work out.

Nevertheless, people (like me) still go for these kinds of deals because the potential returns are higher than you can get from most any other kind of property investment. It’s like investing in a pre-IPO offering; you expect to make big profits once the company goes public.

The reality, though, is that most pre-IPO companies never go IPO.

The easiest way to lose most or all of an investment in real estate anywhere is leverage. Again, though, an opportunity to leverage can be tempting because it can be a way to create maybe much higher returns.

I used leverage with my first real estate investment more than 20 years ago. This one happened to be in the United States, where leverage is much more possible than in most of the rest of the world.

I was able to buy a three-flat building in Chicago with US$5,000 and then to turn that US$5,000 into US$150,000 in less than three years. I sold the building for 80% more than I had paid. After agent fees and other closing costs, I walked away with a phenomenal return.

However, had my property value dropped by even less than 3%, I would have lost my entire investment.

Leverage is a double-edged sword. Don’t use it unless you’re comfortable with the worst possible outcome.

Because, in fact, there are lots of ways to lose money in real estate (just as there are lots of ways to lose money investing in anything), I made a rule years ago that I would not invest more than 5% of my net worth in any single investment.

This doesn’t work when you’re getting started building a portfolio or working with a modest overall net worth. If 5% of the total available for investment amounts to less than US$50,000, you’ll find it hard to find viable opportunities. It’s possible… and I could name a few that I’d recommend right now… but it’s not easy.

Of course, rules are made to be broken, and I’ve broken my 5% rule many times over the years. When I break the rule, I spend more time, effort, and money on the research and due diligence than I normally would. And the greater the level of risk or the amount of leverage in place, the lower the percentage of net worth I’ll consider investing.

Lief Simon

P.S. My trip to Thailand is to research a new agricultural project with a temptingly low capital requirement. Unlike the developer deal I did so many years ago, this project isn’t pre-construction. It’s already under way, albeit for a short time.

The paperwork due diligence passed muster so I got on a plane to see what things look like on the ground. I’ll report back to my Global Property Alert members first, assuming the project continues to hold up after closer scrutiny.