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Imprudent Use of Leverage: A Contrarian Opinion

by Brian Brady on January 22, 2010 · 6 comments

  

Contrarians zig while other investors zag.  They hold to the belief that most people receive news too late and act irrationally.  Warren Buffett illustrates the contrarian approach best:

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.

Let’s talk about how mortgages can be applied to the Buffett School of Contrarian Economic Theory;  you should probably be maxed out to the hilt on your properties.  “Mortgage Planning” was a sales technique we debt peddlers used, during the boom.  We dressed up serial refinances, to the maximum permitted loan-to-value, and called it “home equity harvesting“.  The theory suggested was to make money from arbitrage opportunities by borrowing against your (appreciated) principal residence at x% and investing that money at (1.25) x%.

Financial advisers like Ric Edelman championed this cause by lending credibility to the theory through best-selling books.   Seminars were held by guys in thousand dollar suits, displaying multi-color charts, showing how the incremental benefit of that arbitrage, compounded over time, could result in a king’s ransom for the intelligent “investor”.  They forgot to discuss the key ingredient to the use of leverage…

Can you service all of that debt?

The real estate market tanked, the stock market dove, and junk bonds defaulted, leaving those “investors” with depreciated assets, bought with money they couldn’t afford to repay.  A sad tale of woe, indeed.

Still, I think you should “bet the ranch” today.  Here’s why:

There’s a catch, though.  You must be able to afford all of that debt. If you borrow an extra $100,000, to buy $300,000 worth of property, be certain that the income being produced from that $300,000 services ALL of the debt incurred, including the marginal monthly increase from the withdrawn home equity.

The whole world is talking about the great de-leveraging in which governments, businesses, and consumers are engaged.  They’re all zigging so I say you should zag.  If they’re saving and receding,  you start borrowing and buying.

A contrarian opinion.  Caveat Emptor.

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{ 5 comments… read them below or add one }

Greg Swann January 22, 2010 at 9:46 am

Thanks for the mention. I think this is sound advice, straight down the line. This is no market for the faint of heart, but if you’ve got some risk tolerance in your character, there are gemstones to be had at bargain-basement prices.

Reply

Joshua Dorkin January 22, 2010 at 11:07 am

I’m with both you and Greg on this one. Market conditions are such that, at least in my humble opinion, we’re in as great a time to invest in some real estate as we’ve ever been. With proper due-diligence, you can scoop up plenty of diamonds in the rough, while keeping the risk to a minimum.

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Jeff Brown January 22, 2010 at 11:32 am

As usual, Brian, excellent post. What is surprising is how so many investors discuss leverage when they’re completely unaware of it’s primary investment-related definition.

You touch on it with your mention of arbitraging. Hope we see more of you here.

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Brian Brady January 22, 2010 at 12:17 pm

It’s a pleasure to be here, Josh. Thanks for the invitation and I appreciate the referral, Jeff.

Readers should not that Greg and Jeff are two real estate brokers in whom I would place my trust. Greg’s “hot list” is always an interesting read

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Frank Schulte-Ladbeck January 23, 2010 at 4:30 am

So far the contrarian practice has worked out for me in my stock portfolio, but REITs are still taking a bashing. I imagine it is a matter of being able to deal with this debt for awhile to ride our current economic circumstances out. I am glad that you highlighted that fact. Investors have to understand what the costs are, and how to make a profit.

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