Understanding the Power
and Use of Leverage in the Investment Property Game
Archimedes, the ancient Greek mathematician, once said that with a long
enough lever and a place to stand the fulcrum, he would move the world.
Applied in the financial world, leverage refers to the borrowing of
capital against the value of an asset, in order to increase the return
on cash equity contributed by an investor. Total returns are enhanced
provided the cost of borrowed capital (i.e. the interest rate paid on
the borrowed funds) is less than the yield earned on the asset itself.
Nowhere is this concept better demonstrated than in the U.S. real estate
market, where homeowners utilize unprecedented borrowing capability to
purchase property. With 90 to 100% loan-to-value mortgages offered in
abundance, residential mortgage borrowers can use their capital to buy
bigger and better homes than ever before, or refinance to take cash out
to use toward other investments.
However, while such high leverage products have made their way to the
residential mortgage landscape, the same cannot be said of the
commercial lending industry. Here, loan parameters are set by the
predominantly credit conservative, risk averse commercial banks, who
require more capital contribution by their lending customers.
That said, rental property investors looking to lever commercial real
estate, be it a multi-family building, strip mall, or office building,
aren’t likely to find anything higher than a 75% loan-to-value at their
bank. However, research reveals alternative niche commercial mortgage
lenders willing to offer 90% loans commonly used in the residential
mortgage industry. Such mortgages offer tremendous value to commercial
property investors looking to enhance the return on their money.
Consider the following comparison of two commercial property investment
scenarios, one funded through a typical commercial bank, and the other
through a high leverage alternative lender. In this example, we assume
the investor has $100,000 of his own capital to invest in the property.
The Power of Leverage
In Scenario A, the investor is limited to purchasing a $400,000
property since the bank will only lend $3 for every $1 the investor
contributes (75% LTV).
In Scenario B, the investor can afford to purchase a property 2.5 times
more valuable than in Scenario A ($1,000,000) since the lender offers $9
for every $1 the investor contributes.
Property Purchase
|
Scenario A:
|
Scenario B: | |
|
Down Payment (Equity) |
$100,000 |
$100,000 |
|
Maximum LTV Ratio |
75% |
90% |
|
Total Purchase Price |
$400,000 |
$1,000,000 |
|
Mortgage Loan Amount |
$300,000 |
$900,000 |
|
Mortgage Interest Rate |
7.00% |
8.25% |
Now, consider the profits earned in Scenario A vs. Scenario B in a one year time frame, given equivalent assumptions for net rental income as a percentage of value (8%), and property appreciation as a percentage of value (5%). We’ll further assume the interest rate on the loan offered by the bank in Scenario A is 7.00%, and the alternative lender loan rate in scenario B is higher at 8.25%.
Year 1 Interest & Expenses
| Scenario A:
Bank Loan |
Scenario B: Alternative Lender Loan | |
| Net Rental Income (8%) | $32,000 | $80,000 |
| - Interest Expense | $21,000 | $74,250 |
| = Net Operating Income | $11,000 | $5,750 |
| + Property Appreciation (5%) | $20,000 | $50,000 |
| = Total Income | $31,000 | $55,750 |
| Return on Equity | 31.0% | 55.8% |
In Scenario B, the investor was able to
"lever" his $100,000 to buy a larger property, earning an additional
$24,750 over the year. Put another way, by using the alternative lender,
the return on the equity investment of $100,000 increases from 31% to
almost 56%. Additionally, while this analysis shows the return
differential over one year, the contrast becomes even greater over a
longer period, as the property continues to appreciate.
The above example illustrates how extra leverage can be a powerful tool
in enhancing returns in your investment real estate. The challenge for
investors then, is to find the right lending program that offers both
the best leverage and attractive rates and terms to best meet their
goals. Instead of simply defaulting to the loan offered by their local
banker, investors should do some diligent research on alternative
programs, starting with the Internet. Choosing the right lender can make
all the difference in your investment success. I’m sure Archimedes would
agree.
Articles
Understanding Leverage
Issues Commonly Associated with the Purchase of Commercial Real Estate
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