Leverage: How to Get More Out of Your Real Estate Investments
In real estate, the term leverage refers to the origination, application and impacts of debt (typically, a loan recorded on title) that is specific to a property or portfolio. The debt is provided by an individual or entity that has the expectation of, and usually contractual right to, the repayment of principal with accrued interest, paid over a period of time that is specified in the loan docs.
Leverage is also commonly used in reference to whether borrowed capital increases or decreases (or is projected to increase or decrease) investment returns. It is used in conjunction with investment performance metrics, either for an entire project (e.g. “a total levered IRR of 5%”) or interim cash flows (“leveraged cash on cash returns”). Both applications are used for all property types.
Positive vs. Negative Leverage
Leverage is often characterized as being either positive or negative.
It’s a common misconception that positive or negative leverage is determined by comparing an interest rate to a property’s cap rate or cash-on-cash returns expressed as a rate. The assumption is if the interest rate on the loan is higher than one of these metrics, leverage is negative, and if the interest rate is lower, leverage is positive.
Without comparing an all-cash scenario and a leveraged scenario, an investor can determine if leverage is positive in terms of cash-on-cash returns by comparing a cap rate for a given year (net operating income, price paid and/or value) against a “loan constant” (mortgage capitalization rate), which is the total loan payments for a given year divided by the average principal balance. Using that year’s balance instead of the original balance takes into account the “sinking fund” factor which refers to payments getting progressively higher relative to a sinking loan balance as a loan amortizes.
To determine whether leverage is positive or negative for a project (acquisition, all interim cash flows, and disposition), the project level internal rate of return (IRR) should be compared with the total cost of borrowed funds (interest and other costs, divided by loan amount, expressed as a rate). One can conclude that leverage is positive when a project IRR is higher with a loan compared to the same project without the same loan.
Here’s a quick guide:
Positive/Negative Leverage Used In Reference to Cash Flow
Loan Constant is greater than Cap Rate = Negative Leverage
Loan Constant is less than Cap Rate = Positive Leverage
Positive/Negative Leverage Used in Reference to Project
(all cash flows for all years and benefits of sale)
Project IRR (excluding loan) is less than total cost of borrowed funds (expressed as a rate) = Negative Leverage
Project IRR (excluding loan) is greater than total cost of borrowed funds (expressed as a rate) = Positive Leverage
The Impacts and Risks of Leverage
When it comes to applying leverage to a real estate investment, interesting things can happen.
On the positive side of things, leverage can make mediocre deals with low returns turn into home-runs. It can also allow under-capitalized borrowers to raise a relatively small amount of equity and compete with institutions on large assets.
However, when times get tough, people can see their net worth and even cash flow go from seven figures to zero in a matter of months because of leverage. As Warren Buffet said, “Only when the tide goes out do you discover who's been swimming naked.” The last point is not limited to high-risk inexperienced developers: in 2007-2008, equity for certain property types in non-coastal markets dropped by over 60%. This means that even investors with loan-to-value ratios that were conservative by national standards, lost everything. For every five investors that took a bath (lost everything) there was one investor that owned properties free and clear or with a low enough debt profile to weather the storm.
(And in case you’re counting, that is now three water-related analogies in this article.)
Here is a simple example of how leverage can impact equity returns. Let’s say an investor is buying an investment property that he will hold for five years and sell at the end of year five. The purchase price is $100, generates $10 of cash flow per year, and sells for $150 (assume $0 costs of sale).
Scenario A: All-cash purchase
Cash invested: $100
Annual cash flow: $10/yr.
Sale proceeds: $150
Unleveraged Annual Cash on Cash Returns: 10%
Unleveraged Internal Rate of Return (IRR): 17%
Scenario B: Purchase with loan with the following terms: $70 (70% Loan-to-Value Ratio, 5.0% interest rate, 30-year amortization)
Cash invested: $30 ($70 of the purchase is funding by the loan)
Annual cash flow: $5.50
Sale proceeds: $80
Leveraged Annual Cash on Cash Returns: 18%
Leveraged Internal Rate of Return: 35%
As you can see from this example, leverage can dramatically impact return projections, and almost always do. What is not usually shown in projections is what happens when things don’t turn out so well. Therefore stress testing an investment opportunity is a wise practice that can keep investors prepared for less-than-ideal market conditions.
As with everything in real estate finance, it’s important to know your concepts well and see the potential—both positive and negative. Leverage is just one—yet very necessary—piece of the puzzle.