Editor’s note: This article was first published in January 2017, and its Facebook and Uber examples of leveraging other people’s work reflect how those companies were described in 2017.
In the same way that the secret of great fortunes lies in the magic of compound interest, when billionaires give their advice on building a great fortune, they often talk about using other people’s money.
We are talking about the magic of leverage, a concept familiar to stock market investors that we have discussed before, always bearing in mind that it can be as effective as it is damaging if we don’t know how to use it properly.
For those who wonder how the rich do business, or about the secrets usually sold in courses on “get rich quick investing in property with no money”, we are going to explain it in a simple, easy-to-follow way. We’ll use round numbers to make it easier.
(See also: 8 ways to invest in real estate)
Imagine that Pedro buys a house for 1,000,000 euros (one million euros). He puts in 100,000 euros of his own money and gets a bank loan for 90% of the property’s value, that is, 900,000 euros, at an interest rate of 5%. Let’s suppose that after one year the house has gone up in value by 10%, so it is now worth 1,100,000 euros (1.1 million).
Pedro sells his house for that amount (1.1 million) and pays the bank the 900,000 euros plus interest (45,000 euros), which leaves him with 155,000 euros.
So from an investment of real money (Pedro’s own) of 100,000 euros, he made a profit of 55,000 euros, a 55% return on the speculative deal, even though the property only rose in value by 10%.
What if Pedro gets a loan for 95% of the value of the house?
In that case he would only have to put in 50,000 euros and would make a return of 100,000 euros, a 100% return on the money invested, with the same rise in the value of the house. And that is the magic of leverage.
This is the great secret of investing in property without money, and it is how the rich grow their empires. Of course, it has to be said that the rich don’t use this only for real estate investment. They also do it with their businesses, their factories and so on.
When people debate whether debt is good or bad, this way of taking on debt in the expectation of a much higher return is undoubtedly good. Ultimately, the expected return must be higher than the interest we have to pay on the loan. That much is obvious.
The danger of leverage?
The most obvious danger of leveraging yourself this way is that leverage works in both directions. If, instead of rising, the price of the house ends up falling by 5%, Pedro would have a house worth 950,000 euros while owing the bank 945,000 (loan plus interest), leaving him with just 5,000 euros of “profit”. In other words, he would have lost 95% of his money. If the house falls further, not only would he lose 95% of his initial 100,000 euros of capital, but the amount he owes the bank would grow.
That is why rich people can become very rich and, at the same time, find themselves ruined if they don’t diversify their activities or if they take on leverage in toxic assets.
Naturally, these people usually analyse many other factors carefully to make the risk-return equation work in their favour.
But there are many ways to use leverage.
As Francisco Alcaide, author of Aprendiendo de los mejores (“Learning from the best”), explained in an article we published, people who earn a lot of money don’t only use leverage in this way; they also use it to get other people to work for them.
Facebook is one example. Facebook has no need to create content, because we users create it. Put more simply, we are the ones working for free so that Facebook can generate revenue.
UBER does the same with its fleet of drivers: a way of having a workforce that generates revenue for UBER without having to hire people or spend money on a fleet of vehicles.
In short, leverage also means multiplying the time other people put in to grow our profits.
And that is why success requires certain skills: negotiation, sales, public speaking, the ability to influence others and so on. To get money from other people, you first have to convince other people (in this case, a bank to give you a loan).
To sum up: successful people use the help of others, leveraging other people’s money, time, energy and talent. That is how they build great empires and make their companies far more profitable.
As easy, or as hard, as that.
See also: This is the best question to measure the health of your personal finances
Featured image: Mechanics Magazine, Public domain, via Wikimedia Commons.
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