What is Leverage?
Leverage is the use of debt to increase the potential return of an investment. By using leverage, investors can control more property and potentially increase their Return on Equity (“ROE”) invested. There is no “correct” method of employing leverage. Some investors prefer to maximize leverage (usually 75% Loan to Value (“LTV”) in today’s multifamily market) and assume the additional risk that comes along with it (i.e., obligation to make monthly debt service payments or foreclosure if those payments can’t be made). Other investors prefer to own their apartment buildings “all cash” and minimize their risk, while possibly sacrificing some ROE. Of course there are all shades of grey in between those two ends of the spectrum.
When clients ask me to review their portfolios and make suggestions for increasing Before Tax Cash Flow (“BTCF”), ROE, and Net Worth over the long term, I always remind them of the potential risks and rewards of using leverage. By comparing Scenario #1 (all cash, no leverage) with Scenario #2 (50% leverage), we can investigate how the use of leverage increases the ROE and BTCF over the course of an example 10-year holding period.
|Down Payment (or equity deployed)||$1,000,000||$1,000,000||$0|
|Assumed Inflation Rate||3.00%||3.00%||0.00%|
|Year 1 Cap Rate (unleveraged return)||6.12%||6.12%||0.00%|
|Year 9 Cap Rate (unleveraged return)||7.75%||7.75%||0.00%|
|Year 1 Return on Equity (leveraged return)||6.12%||6.12%||0.00%|
|Year 9 Return on Equity (leveraged return)||7.75%||9.39%||1.64%|
|Cumulative Positive Cash Flow||$978,310||$1,542,856||$564,546|
|Internal Rate of Return||8.72%||11.85%||3.13%|
In both cases, $1,000,000 of capital is deployed and a Year 1 Cap Rate (or Unleveraged Return) of 6.12% is achieved. In both cases, the Year 9 unleveraged return is 7.75%, which is slightly higher than Year 1 due to our assumption that rents will rise at a rate of 3% annually.
Return on Equity or Leveraged Return
In both cases, a Year 1 ROE of 6.12% is achieved. In Scenario #1, the ROE stays constant with the Unleveraged Return throughout the life of the investment, reflecting the fact that there is no leverage. It’s in Scenario #2 that we begin to see the benefits of leverage. Over time, Scenario #2 ROE begins to grow, to 6.49% in Year 2, to 6.87% in Year 3…..to 9.39% in Year 9. This is due to rents continuing to rise with our assumed inflation rate, and the mortgage payments remaining constant (assuming 10-year, fixed-rate loan terms).
Before Tax Cash Flow
Another place we see benefits of leverage is in the BTCF. Although both Scenarios contemplate deployment of $1,000,000, Scenario #1 results in BTCF of $978,310 compared to BTCF of $1,542,856 for Scenario #2 (a 57% increase). This is due partially to the rental rates rising and mortgage payments staying constant as mentioned above, and also due partially to the fact that the loan principal balance was being paid down over the course of the 10-year holding period. The investor assumed debt of $1,000,000, enjoyed higher ROE over the holding period, and only had to repay $802,171 at the time of sale, a BTCF benefit of $197,829 not shared by Scenario #1.
Internal Rate of Return
The benefits of leverage are on display by comparing the Internal Rate of Return (“IRR”) from unleveraged (8.72%) and leveraged (11.85%) scenarios – that’s an article for another day.
As we’ve seen, aside from the loan principal balance being paid down over time, the main benefit of using leverage is that mortgage payments can remain constant while rents rise in line with inflation or with the supply/demand forces of the rental market. In this case, we’ve assumed rents continue to grow at 3% per year. Over many decades, that’s probably a safe assumption but as we’ve all experienced, there are certain times in the increasingly volatile economic cycle when rental rates turn around and go the “wrong” direction, or when there are multiple vacancies at once, causing income to drop. The obvious problem is that if income happens to go through a rough period, the debt service obligations on the leverage don’t disappear. If income drops enough to cause difficulty meeting the monthly debt service obligations, the investor needs to pay the loan payments with cash from another source. If the situation persists, some investors eventually succumb and give the property back to the bank….there is no greater RISK to an investor than giving up their property. In order to take advantage of the benefits of leverage while also limiting risk to the extent possible, some investors prefer not to go above 50% LTV. The idea is that if rental rates drop or vacancies surge, they’re unlikely to cut income by a full 50% and cause the problems detailed above.
When clients ask me how to increase the performance of their capital, in some cases I recommend they consider leveraging up (i.e., take on debt) in order to pull equity out of an investment that has plenty and move it over to a new purchase, thereby controlling more property and increasing their BTCF, ROE and Net Worth, over the long term.
Albert Banks has over 25 years experience as a licensed Real Estate Broker. His ability to recognize opportunities in the changing real estate market has benefited many of his clients by increasing their real estate portfolios and net wealth. Because of this commitment, clients continue to seek his professional opinion regarding market trends, property values and future opportunities. His clients always come first and paying attention to details is his mission.
Albert found his niche specializing in the sales and marketing of multi-family and commercial properties. No transaction is too difficult, too small or too large. His years of experience have allowed him to successfully complete difficult transactions, with title issues as well IRS 1031 tax deferred exchanges. For more information, please call (818) 988-9200 x125 or email [email protected]