In part 1 of this post, I set out the case for maximising debt and minimising the amount of debt that is repaid. Essentially, the logic is that there is a reasonable expectation that other investments such as equities will produce returns which are higher than the interest rate being paid on borrowings.
Of course, nothing is that easy and part 2 of this post attempts to explain the pitfalls:
1. it assumes that the historic long run average returns in equities will continue to be achieved in the future. There is no certainty that this will happen. At least part of the historic long run returns on equities can be attributable to expanding valuations (e.g. higher price earnings ratios) rather than expanding earnings. This is not something which I believe can continue indefinitely;
2. it relies on average returns being achieved. Financial plans which rely on achieving average returns each year have a high probability of failure (a subject for another post I think). There have been several periods where below average returns have persisted for many years. The recurrence of a lengthy period of below average (or negative!) returns would be highly prejudicial to this strategy;
3. the interest rate on the debt is floating. Given that fixed rates are difficult to obtain in Hong Kong for periods longer than five years and prohibitively expensive even for periods less than five years, there is little that can be done to mitigate this risk. If borrowing costs rise, then the positive carry will initially shrink and may well become negative making it a losing strategy. Also, the economic conditions that produce rising interest rates (as well as the rising interest rates themselves) are the same economic conditions that may well result in a decline in the value of investments;
4. cash flow may be negative. Even though the total return on equities may be greater than the cost of borrowing, the yield received through dividends is almost certainly going to be lower. Also, interest payments will typically need to be made every month (I have one mortgage on fortnightly payments) while dividends may be received only once or twice a year. Cash has to be found to meet the payment schedule on the debt and that cash will not always be available from the investment in equities;
5. opportunity cost. Carrying high debt levels may make it harder, if not impossible, to take advantage of attractive investment opportunities as and when they arise. In particular, at times when the markets are depressed and valuations are most attractive, your loan to value ratio is likely to be at its worst and the banks are likely to be most conservative in their lending policies and practices making it harder to fund acquisitions. Another opportunity cost is that carrying high levels of debt will reduce career opportunities - in effect moving to lower paying or part time employment may be more difficult.
I have not addressed tax issues as these are more likely to be a benefit than a burden for me as a Hong Kong resident. However, investors domiciled in other jurisdictions may have to take the effect of tax into consideration in doing their own analysis.
I have also assumed that all the debt raised is secured against real estate which, based on current lending practices, will avoid the risk of a margin call.
In part 3 of this post I will look at how I balance the potential returns from using debt against the risks identified above.