“Real Estate leverage is a beautiful thing…” I say this often when discussing investments with my friends and clients. And of course, leverage can also lead you down a dark path if you are not careful. But, if you play the game conservatively, it can change the way you view an investment.
When thinking about investments, there are very few if any that allow you to borrow the way you can when purchasing real estate. Commercial real estate lenders typically lend up to, and sometimes more than, 75% of the total investment price; they usually offer fixed interest rates over a 5-10 year period; and they don’t have a “margin call”, which is a standard loan term when borrowing against your securities investment account
What other investment offers this kind of leverage and terms? The answer is none. Not stocks, not bonds, not mutual funds, not REITs, etc.
Of course there are many other important factors involved in an investment decision (i.e. risk, control, holding period, etc.), but let’s focus on leverage and its potential impact on investment return for now.
It doesn’t take a math whiz or MBA recipient to understand the “return on an investment” when utilizing leverage. Consider the following example:
Investment 1 vs. Investment 2 – ($100,000 cash outlay for both Investments)
- Purchase Price of investment $100,000. Investor pays all cash and has a total cash outlay of $100,000. The annual rate of return on the investment is 7% of the Purchase Price. The first year Profit is $7,000 or 7% of the Investor’s cash outlay.
- Purchase Price of investment $400,000. Investor leverages the investment and obtains a loan for 75% of the total Purchase Price or $300,000. Therefore, the investor’s total cash outlay is the same $100,000 as in Investment 1. The annual rate of return on the investment is 7% of the Purchase Price. The first year profit (before loan costs) is $28,000. Assuming an interest only loan at 5%, the total loan costs in year one are $15,000. After deducting the loan costs from the gross profit, the Net Profit equates to $13,000 or 13% of the of the Investor’s cash outlay.
Don’t look into this example too hard, again there are numerous other factors to consider in an investment, but hopefully it clearly illustrates the impact of leverage on the rate of return.
Now, let’s look a little deeper into a real estate investment and the impact of leverage. (Warning: If numbers scare you, you may want to look away.)
Over the past 20+ years I have worked with many clients and partners on purchases of properties utilizing various forms of leverage. Here is one in particular that will provide a decent example of the leverage impact.
- Purchase of a 36-unit apartment project 1st Quarter 2013
- $4,525,000 purchase price
- $1,131,250 down payment (25% of purchase price)
- $3,393,750 loan amount (75% of purchase price)
- Loan Terms: 3.44% interest fixed for 5 years, with a 3%/2%/1% pre-payment penalty
- $6,691 loan/title/escrow/misc. fees
- $1,137,941 total cash outlay (Down Payment plus fees)
- $44,116 1st year Cash-on-Cash Return (3.88% total cash-on-cash return)
- $65,798 1st year Principal Pay-Down of Loan
- $109,914 1st year Total Return (9.67% return on initial cash outlay)
If the property was purchased with 100% cash, the 1st year Total Return would have been approximately $225,628 or 4.99% of the initial cash outlay.
Another benefit to “playing the leverage game” is the magnified increase in equity build-up (as compared to your initial cash outlay) when market values are moving in your favor.
Looking at the example above, fortunately market values were moving upward for apartment projects in the region during the short holding period of less than 2 years.
- Sale of the 36-unit apartment project in 3rd Quarter 2014
- $5,250,000 sale price
- $163,588 commission/escrow/title/misc. fees
- $66,110 pre-payment penalty of 2% in 2nd year of loan
- $5,020,302 sale price (net of costs)
- $3,305,500 remaining loan balance at sale
- $1,714,802 proceeds from sale
- $576,861 Net Proceeds from sale less initial cash outlay of $1,137,941
- 50.69% return on the initial cash outlay
Again, if the property was purchased with 100% cash, the net proceeds would have been approximately $5,152,522, which when considering the initial “all cash” outlay of $4,531,691, the total Net Proceeds from the sale would have been $620,831. This equates to a 13.70% return on the initial cash outlay.
However, it is important to remember that when playing the “leverage game” there is also a magnified decrease in equity loss (as compared to your initial cash outlay) when market values are moving against you. So it is important to keep your risk at a comfortable level. One of the main ways we try and reduce risk is by keeping the initial investment focus on cash-flow as opposed to equity building.
I know what you are thinking… “If it’s so easy, why doesn’t everyone do it?” The answer is simple, market uncertainty, which brings us right back to risk. So the solution for many very conservative investors is to avoid the “Leverage Game” all together and pay cash for an investment. That way they know for certain the extent of the downside or potential loss. But if the “Leverage Game” is well thought out before it is played, the impact on rate of return can be significant.
Authored by Kevin Falsken, President & Founder