An Exchange of Opinions # 27- Mortgage Leverage
By Klarise Yahya, Commercial Loan Broker, DRE: 0095710 MLO: 249261
If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book Stairway to Wealth available at LuLu.com.
In the sentence, We’re in the business of providing homes for people the operative word is business. That means that when we invest we seek buildings and locations where we’re most likely to maximize our ROI. Return on Investment comes in two major forms: cash flow from operations and profit upon sale (reversionary profit). Cash flow (net before taxes) is what you can put in your purse at the end of the year (year, not month, because we always annualize this stuff). Cash Flow is net operating income (NOI) minus debt service (DS). Reversionary profit, on the other hand, is sales price minus costs of sale minus unpaid loans (encumbrances).
This Letter discusses a few things other investors have done to maximize their expected reversionary benefits. Sometimes these approaches segue over into enhanced cash flow from operations.
Network Effects refer to those neighborhood amenities that are within walking distance. Examples include a grocery store, dry cleaning, manicurist, a book store, perhaps even employment. Network Effects have important consequences in that the better the quality and quantity (the greater and more numerous the variety and the more upscale) of stores in the area, the more likely someone would wish to rent in your building. And then there’s an interesting feedback loop. Imagine a nice neighborhood, you can get almost everything you need within a block or two, and there is seldom a vacant apartment. Rents trend upwards. So the loop is this: the nice neighborhood generates full apartment buildings which, in turn, draw wealthier tenants who, in turn, support more and better upper end shops, until equilibrium is reached.
So the question is, do we buy our next building in Yermo or Costa Mesa? Well, Yermo is 13 miles east of Barstow. It consists of a three square mile storage annex for the Marine Corps and not much else. You have to go to Barstow to get your nails done. Costa Mesa has South Coast Plaza.
Now, if we were ready to buy another building where would we wish it to be? Next to a Marine Corps Storage Facility or walking distance to Manolo Blahnik’s? The correct answer is as close to South Coast Plaza the valet attendants will allow. And South Coast Plaza is not the only Network Effect. ‘s a half-hour (depending on traffic) to the beach. The Orange County Performing Arts Center is nearby. There’s an In-N-Out. All these, and more, contribute to Network Effects and cause our new building to (a) cost more when we buy it, (b) rent for more while we have it, and (c) sell for more when we move on. Notice that these are not offsetting beneficia. Because the ultimate disposition price will be a function of (expected) higher net income, we anticipate the eventual sales price to overwhelm our purchase price. Costa Mesa (buy high, sell high) is probably going to be a better long term investment location then Yermo (buy low, sell low) simply because there’s more to do there. There are, in other words, positive Network Effects. See WalkScore.com.
‘s easy to overlook the leverage of Inflation. What we’re talking about is using inflation in a way that benefits us. It works best if you have a fixed rate, fully amortized mortgage, because then you transfer the risk of future inflation to the lender. If you have an adjustable rate mortgage, the bank transfers the risk to you. Most loans are hybrid, with a fixed rate period of five or perhaps seven years before it turns adjustable for the remaining term. Please note that the fixed period, when the bank carries the risk of inflation, happens before the deleterious effects of compounding inflation really have time to establish themselves. That means that while the bank shoulders the initial period of inflation, you pick the next twenty years, when compounding really sets in. As you would expect, bankers work for the bank, not for you.
Higher interest rates caused by inflation (there are other less common causes of higher interest rates, like torrid growth) simply demonstrate the erosion of the dollar. If we could forecast the likelihood of the dollar weakening internationally we could estimate the possibility of inflation. Here’s something to just think about. If the national budget remained the same while inflation averaged 10% annually during the first seven years of Romney’s presidency, the debt would be cut in half. Sort of makes one think the government might have a vested interest in controlled inflation, regardless of who’s sitting in the oval office, doesn’t it?
Sauce for the goose time. If inflation has such an effect, wouldn’t it also reduce (in real dollars) our mortgage balance? Well, yes. If seven years of 10% inflation caused the real balance of your apartment mortgage to reduce by half, wouldn’t that be a good thing? Like always, people who have hard assets during inflationary times tend to benefit. If you don’t have hard assets, your wealth will flow to those who do. That’s how it works. Read When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany. ‘s really interesting.
Equity Build Up
As your tenants pay off the mortgage, your loan is worn away a little bit every month. That’s different from the value of your building going up simply because of inflation. Inflation raises all boats. Imagine you bought a building for $1,000,000 cash and, after seven years of 10% inflation you sell it for $2,000,000 cash. Now you look around for someplace to reinvest all that wealth. Following a diligent search you find that, after paying the real estate agent, the enthusiastic one with Senior Investment Advisor on his card and zits on his face, you can’t even buy your own building back. Your building’s value increased only because the dollar went down: it was all due to inflation. You only made a phantom profit, but you still have to pay taxes on it. You’re behind by (a) the cost of selling your property and (b) the taxes due.
Equity build-up is different. It raises your boat. For example, instead of paying cash, imagine we used our hypothetical $1,000,000 to make a 25% down payment on a $4,000,000 building. After 30 years the loan is paid off. Our $1,000,000 turned into $4,000,000 net of inflation.
And that’s the difference. Inflation raises the selling price of our building; it raises the sales costs and the taxes due, but it does not give us a real return. Equity build-up gives us a real, after-inflation return. Is that neat, or what?
Reflect on that while I get you a cup of tea. This is what it means: in an inflationary period you will grow richest when your buildings are fully mortgaged with fixed rate debt. This can be done, sometimes, with a simple 20 year fixed rate mortgage; sometimes it must be accomplished with a series of five or seven year fixed rate periods. But if you think inflation will reappear, it probably should be done. If you think inflation is not in our future, carry on as you were.
The cap rate tells you how much you get (as a %). The Mortgage Constant tells you how much it costs you (again, as a %). Mortgage Leverage can multiply your cash-on-cash returns by two or threefold, which is a blessing.
Mortgage Leverage is not hard to work out, and only elementary school math is required. As you’ve probably gathered by now, there are three steps: (1) Find your cap rate. (2) Find your Mortgage Constant. (3) See which one is bigger.
Capitalization Rate: We’ve talked about this before, but for the new girls here is what a cap rate is . . . it is functionally similar to an interest rate. ‘s what you get and it’s expressed as a percentage of the purchase price. If it were an interest rate and you put $1,000,000 into your savings account and got $40,000 a year in interest (we wish!) you would be earning 4% interest. If you used the same $1,000,000 and paid all cash for a property (remember, no loan) and got the same 4% cash return, it would be called a cap rate. Interest rate, cap rate. Tomatoes, tomaaatoes. For wonks, the formula for cap rate is: Net Operating Income (NOI) divided by purchase price.
(To Find NOI: Gross Scheduled income (minus) vacancy and credit losses equals Gross Effective Income. Gross Effective Income (minus) fixed and variable expenses equals Net Operating Income. NOI is what you could put in your purse if you paid cash for the property and had no loan payments.)
A hypothetical example: A rent roll shows a property bringing in $180,000 annually. Subtract vacancy and credit losses (est. @ 7%) and our Gross Effective Income is $167,000. Subtract Taxes, Utilities, Management, Maintenance, and Insurance (est. @ 38%) and we arrive at our NOI of $104,000.
If we paid $1,300,000 for the property the math would be (NOI ($104,000) divided by purchase price ($1,300,000). The cap rate would be 8%. This is an example only. The reason cap rate is important is that it tells us what we’re earning on the investment.
Mortgage Constant: Ok. We’re done with pretending we paid cash for a building. Now we’re returning to the real world and accepting that we’ll probably borrow money to buy those units. The Mortgage Constant is the relationship between the annual debt service (principal and interest payments) and the amount borrowed. ‘s expressed as a decimal. The Mortgage Constant tells us what we have to pay (principal and interest) for the borrowed money.
There are two ways to calculate the Mortgage Constant, the complicated one that I forgot and the simple one that everybody remembers. Mortgage Constant (simplified formula): Put the annual debt service (ADS) in your calculator, press the divide button, put in the original loan amount and press equals. The number in the screen will be in decimals and has to be multiplied by 100 to get a percentage. Go ahead and multiply by 100 because what you want is the percentage.
Example: Mycroft borrowed $2,000 at 5% fixed interest, payable at $10.74 monthly, and fully amortized over 30 years. What is his mortgage constant? Answer:
1: Determine Annual Debt Service: $10.74 x 12 months = $129
2: Divide ADS by the amount borrowed: $129 divided by $2,000 = 0.064 = 6.45%
What that means is that Mycroft pays 6.45% of his initial loan amount each year in principal and interest. We’ll discuss why this is important in a moment.
Mortgage Leverage: Now, this is where it starts to get good. What we want to do is to figure out what we’ll earn on the investment (cap rate), then subtract what we’ll have to pay (Mortgage Constant) to get it. So all we have to do is to see which one is bigger. If the building’s cap rate is less than the Mortgage Constant, that’s bad. That’s one of the reasons why you have to make a big down payment: it’s to get the loan small enough that the NOI will cover the payments.
If the cap rate is more than the Mortgage Constant, that’s good. It means net earnings are enough for the mortgage payments plus a bit left over.
For Illustration Only: What if there was a way to borrow at low interest rates and invest the borrowed money in an asset that yields a higher rate? What if, for example, you could borrow money at a 5% Mortgage Constant and invest it at, say, 8%? Imagine you took your $1,000,000 and bought a $4,000,000 apartment building, like we said, at an 8% cap? Wouldn’t you earn 8% on at least your down payment? Maybe not on the amount borrowed, because you’d have to deduct the payments, but on whatever you put down you probably should expect to earn the cap rate, wouldn’t you think?
But what about the $3,000,000 you borrowed? Assume your payments reflect a 5% Mortgage Constant (what it cost you) but it’s earning you 8%. Wouldn’t you be earning an over-ride of 3% on the borrowed funds?
Three percent of $3,000,000 comes to $90,000. So, you would earn a $90,000 over-ride on the amount you borrowed plus $80,000 on your down payment. You’re making $170,000 on your investment of $1,000,000. That’s 17% cash on cash.
Right now, as this Letter is being written, apartment loans can be had at a 6.08% Mortgage Constant. If you bought a building at a cap rate higher than the Mortgage Constant, you’d be getting an over-ride on everything you borrowed. Like I said . . . a blessing.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].