Commercial real estate is a relatively high dollar asset class, with even “small” properties costing hundreds of thousands of dollars. This is why investors almost always finance a portion of the purchase with a mortgage. Mortgages enables investors to acquire larger properties, but how else does it impact an investment? By way of example, let’s look at the impact of debt on the cash flow, principal reduction and appreciation of hypothetical investment properties.
Ron and Maggie have $200,000 of equity available to invest. They are deciding between an all-cash purchase of a $200,000 property or financing a portion of a $600,000 property. The larger property would be financed with a $400,000 loan with a 5.0% interest rate and a 30-year amortization period.
For this example, assume both properties have cap rates of 8.0%. As you can see below, using a mortgage allows Ron and Maggie to buy a $600,000 property vs. a $200,000 property.
In this example, the total cost of borrowing (interest and principal) is less than the property’s Net Operating Income (NOI) (cap rate of 8.0%), which means both properties have positive Cash Flow. More importantly, the cash flow from the property with debt is $22,223, or 39% greater than the $16,000 produced by the property without debt. As a result, Ron and Maggie’s cash-on-cash return increases from from 8.0% to 11.1%.
In addition to potentially increasing cash-on-cash yields, debt can also provide equity build-up through principal reduction. Assuming a property’s net operating income (NOI) covers its debt service payments, and that the loan is amortizing, then an investor’s equity in the property will increase as debt is paid down. Let’s look at Ron and Maggie’s investment options again:
In the example utilizing debt, $5,901 of the debt payment is attributable to principal reduction, providing another source of return on investment in addition to current cash flow. In this case, holding the property value constant, Ron and Maggie have increased their equity position by 3.0% by using debt. What’s more is that debt reduction is a tax-free benefit to the investor!
Although property values can decrease on a year-over-year basis, commercial real estate has historically provided strong value appreciation. This benefit is again magnified by the use of debt.
Let’s assume after five years Ron and Maggie’s example property has appreciated in value by 10%. Compared to an investment without debt, the leveraged property produces a return multiple times greater both in total dollars and on a percentage of equity basis.
In our example, the use of debt has increased Ron and Maggie’s return on equity through three components: increased cash-on-cash returns, principal reduction, and magnified returns from value appreciation. Assuming no change in annual net operating income, and not accounting for the time value of money, Ron and Maggie’s total return comparison after five years may look like this:
Words of Caution
As we’ve seen in the examples, debt can be a powerful tool for enhancing returns, however, debt also adds risk to an investment:
- Debt magnifies returns in both directions. Just as we saw debt increase percentage returns during value appreciation, the same effect holds true if values decrease.
- Debt adds an additional expense to owning a property.
- Debt payments take priority over equity returns to the investor.
- Loans typically have a fixed date by which they must be repaid. There can be no assurance of the amount or terms of new debt available to an investor when the current loan matures.
The use of mortgages allows investors to acquire larger properties and can also act as a yield enhancer. However, debt also adds risk to the investment. Investors should consider several factors when leveraging their properties. These include predictability/variability of the cash flow generated by the property. The greater the amount of debt (leverage), the smaller the cushion between NOI and debt service.
Which brings us to a final comment. The use of debt to buy real estate is a function of the investor’s personal tolerance for risk. An investor with a low risk tolerance should use less debt.
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