Returns vs Safety: How much leverage is correct?


As a businessmen, an entrepreneur, an investor, the allocation or effort/capital is a common one. Should you put the next $1 into Activity A or Activity B? It can only go to one of those places.

As you grow your business, should you buy that new truck or lease it? Buy that new machine or rent it? If you’re thinking through the acquisition of a company or a piece of property, is it better to take it down with cash or with leverage?

In a theoretically perfect world, where nothing ever goes wrong, and we never make the wrong decision, its a no brainer – you should use leverage every time, and as much of it as you can get. But in the world we live in, where sales don’t always increase month-over-month, where surprise new expenses can come up, and basically anything can go wrong from speeding ticket to full-on Hurricane Sandy, it helps to have a little margin of safety.

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The above is a chart from an investment I was researching earlier this year. I knew I could get a 6% interest loan on it (or better), and was trying to figure out what the optimal amount of leverage was. Of course, as you increase leverage, you exponentially increase the potential returns on equity. However, you also cover the interest payment fewer and fewer times.

As with so many things, the right answer here depends a little on how comfortable you are with risk, and how lucky you’re feeling. If you’ve got the interest covered 2x, and we’re talking about a rental property, that means you could have 50% vacancy and still do just fine. But if you are only just barely making the interest payment, any less than 100% vacancy will bankrupt you.

The same math applies to a garmento buying a factory, or to a huge corporation thinking about leveraging the buyout of another company.

Warren Buffet suggests in many of his annual letters that he’s uncomfortable if he sees any less than 2X interest coverage, and many of his companies have much more than that. But with more liquid investments (sometimes including real estate) 2X could be a lot if you have a conservative estimate of what the equity is worth.

What do you think? I’d be very interested to know how fellow business owners and investors consider¬†their risk & reward.