Leverage is the concept of using other people's money. Specifically, in real estate, leverage means using bank debt, thereby reducing the amount of capital or equity that the investor needs to come up with in order to do the acquisition.
Today I'm going to show you three different examples of investing in the same $1,000,000 asset at an 8% cap rate - one with no leverage, one with 50% leverage, and one with 75% leverage, to highlight the impact on the investor's returns.
A good way to demonstrate this is to think of the cash that is generated by the property, in this case the $80,000 of NOI, as going into a bucket.
With the investor using no leverage, they get to keep all of the cash in the bucket. In this case, they invested $1,000,000 and are getting a cash return of $80,000 each year, for an 8% cash on cash return.
So when we think about leverage, think about it as partnering with the bank, but at a lower cost. In this case, with the 50% leverage the investor is effectively partnering with the lender, but the lender's cost of funds is lower.
The debt service on a $500,000 loan at 4.5% percent amortized over 30 years would be $30,000 per year. The $30,000 debt service divided by the $500,000 outlay in the form of a loan that the bank made equals a 6% cash return, or the lender's loan constant.
If the lender's portion is only $30,000 out of the $80,000, then the remainder goes to the investor in the form of net cash flow. The investor keeps $50,000 of the $80,000. And since they invested $500,000 of their own cash, that yields a 10% cash on cash return.
At 75% leverage, the lender is putting up $750,000 of the capital in the form of debt, and the investor puts up $250,000 in cash.
At that same rate, in terms 4.5% amortized over 30 years, the debt service on that $750,000 is $45,000 per year. Once again, that $45,000 divided by the $750,000 is a 6% cash return to the lender, the lender's loan constant.
That leaves $35,000 in the form of net cash flow left over for the investor. The investor only puts up, in this case, $250,000 of their own cash; $35,000 divided by a $250,000 investment is a 14% cash-on-cash return.
In this case, the investor is only putting up 1/4 of the amount of capital and they're making a significantly higher return on that capital. This is called positive leverage.
Positive leverage occurs when the cap rate is greater than the loan constant, so the return to the lender is lower than the cap rate, allowing the investor to capture some of that net cash flow to increase their return.
The loan constant can change, depending on the interest rate and the amortization. But whenever you have a spread between the cap rate and the loan constant, where the cap rate is higher, it's typically optimal to increase leverage in order to increase the investor's cash on cash return.
Neutral leverage is where the lender's loan constant is the same as the cap rate, therefore not providing any additional benefit to the investor for leveraging, other than reducing the amount of capital they need to invest to acquire the asset.
And then of course, we have what's called negative leverage, and that's when the loan constant is higher than the cap rate. In that case, the investor needs to forfeit additional cash flow to service the debt where the lender is making a higher return.
In order to analyze the optimal amount of leverage to use, simply compare the loan constant and the cap rate. If the cap rate is higher than the loan constant, then use more leverage to increase the cash on cash return. If the loan constant is higher than the cap rate, then less leverage is better in order to optimize cash on cash.
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Trevor T. Calton, MBA is the founder of Real Estate Finance Academy and President of Evergreen Capital Advisors. Since 1997, he has analyzed, acquired, or sold more than $5 billion of commercial real estate assets, financed over 500 commercial investment properties, and overseen the asset management of over 6000 units of multifamily housing.