Leverage in Real Estate

More on LEVERAGE

All loans have three compnents:

Principal : Amount you borrowed

Interest: Amount you pay in interest

Term: Length of the loan

In a fully amortized loan ( like a normal loan you get when you buy a home ) with a monthly fee you pay the interest and a portion toward the principle you borrowed. The payment is always the same for the duration of the loan , what it varies is the percentage that goes to pay the interest vs the percentage that goes to pay the principle, which grows with the time of the loan, while the percentage you pay in interest decreases with the time of the loan. Amortization calculators in Excel are all over the web. I also use 10bii app which mimics HP financial calculator.

Some investors use also interest only loans where you only pay the portion that goes toward the interest. I do not like this type of loan, I like the idea of paying off the principle. At the end of the interest period there is usually a balloon payment. If you are wrong with your investment this a much more risky loan.

Reflections on leverage:

LEVERAGE can amplify the benefit ( and the risks) of Real Estate Investing.   The SPREAD in this case is the difference between the rate of returns of the assets and the interest paid to the bank. 

With the recent COVID issues many commercial rentals are much more volatile than just a few months ago so it is more difficult to calculate the real returns and the real spread.

If you get a property that brings in a 11% IRR or return ( including appreciation that we did ignore up to this point )  then if you borrow money at 5% you actually have a 6% spread and you will have a much higher overall return if you use Leverage.

Basically while you will be making 11% on the money you invested you will also make a 6% or the SPREAD on the money borrowed from the bank so you will make more than twice the money you would make without Leverage.  If however you are borrowing money at 6.00% and the property can only bring a 4% IRR having leverage will actually hurt your finances since the money you borrow will cost you 6%-4%=2% per year and amplify the risks. The only reason you should consider a loan like that is if it is a short term loan ( construction loan ) or you expect a large increase in value of the property.   

 In most cases, however,  if your investor has $400k to invest will he make more by buying with leverage. Example 4 properties with 100k down on each one or will he have a higher profit by purchasing a $400k property in cash as long as the return of the property is higher than the interest you pay. If you can calculate cash on cash return you can help calculate that ( well as usual with all this metrics it is not at all black and white since cash-on-cash return does not consider appreciation income).

LTV Loan to Value

The lower the loan to value the safer is the loan for both the lender and the borrower.

  • <70% Good  
  • > Too 90% High

  ( Usually the maximum the lender accepts for commercial is 75%) the formula is

LTV = Loan Amount / Asset Value

Debt Coverage Ratio

DCR ( or DSCR Debt Service Coverage Ratio)  Is an important measurement in commercial Real Estate.  In a  commercial loan  the features of the property itself becomes gradually more important than the Financials of the investor. The theory behind is that if the property generates enough ‘secure’ cash to cover the loan that will be enough revenue to pay the loan.

DCR = NOI / Debt Service

  The DCR compares the NOI of a property with its Debt service. Example a property that brings in 125,000 a year in NOI and has loan expenses of $100,000 a year will have a DCR= $125,000/$100,000 = 1.25.    Lenders generally like to see a DCR of 1.2 or better. Basically a DCR of 1 means that the loan Cost will be equal to the income of the property.

Debt Yield (used  in commercial loans)  like Cap Rate = NOI / Cost    Debt Yield = NOI / Loan Amount ( looked up by lenders )

Paolo
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