Many investors are and should be cautious about the use of debt. Real estate investors are particularly cognizant of the role debt plays in leveraging the returns on their investments. However, it’s critical to understand the function of debt on an investment and how it impacts the risk and return of that asset. This article focuses on the impact of debt specific to returns.
Fundamentally, debt adds risk to a real estate investment by yielding primacy of claim on the cash flow from an asset.
Debt holders, or lenders, always have claim to the asset and its cash flow ahead of equity holders. But they are capped by the terms of the loan. Equity holders, on the other hand, have the second (or last) claim, but the upside on their investment is potentially unlimited. The underlying risk is that the asset won’t produce the cash necessary to cover the debt service and that the property would be foreclosed upon and reclaimed by the lender. Under such a scenario, the equity investors in the property would lose their principal or cash investment in the asset.
However, the absence of debt on a property does not make a real estate investment a risk-free proposition.
It is possible that the expenses may exceed income, producing a negative cash-flow asset, and/or that when the owner sells the property, they may receive offers for less than they originally paid to acquire it.
So, debt increases risk, but it also must enhance the return on the investment, right? Not necessarily.
This is why it’s important to analyze your proposed investment under the terms of the debt. A scenario where the utilization of debt enhances returns is considered “positive leverage.” Alternatively, a scenario where debt actually detracts from the return is considered “negative leverage.” Next, we’ll break down the mechanics of how each scenario might happen.
First, let’s define a few terms necessary for understanding the mechanics of leverage.
The “debt constant” is the total annual debt service, divided by the total loan amount or “principal.” The debt constant will be higher for a given principal amount when the amortization period is shorter, and when the interest rate is higher. Conversely, the debt constant is lower with longer amortization periods and lower interest rates. Look at the following examples to see how amortization and interest rates affect the debt constant for a particular principal amount of $7,350,000.
Scenario 1 | |
Principal | $7,350,000 |
Terms of Amortization | 30 Years |
Interest Rate | 4.25% |
Monthly Debt Service | $36,158 |
Annual Debt Service | $433,891 |
Debt Constant | 5.90% |
Scenario 2 | |
Principal | $7,350,000 |
Terms of Amortization | 25 Years |
Interest Rate | 5.00% |
Monthly Debt Service | $42,967 |
Annual Debt Service | $515,608 |
Debt Constant | 7.02% |
Scenario 3 | |
Principal | $7,350,000 |
Terms of Amortization | 40 Years |
Interest Rate | 3.75% |
Monthly Debt Service | $29,586 |
Annual Debt Service | $355,028 |
Debt Constant | 4.83% |
Next, the “return on cost” for a real estate investment is calculated as the cash flow before debt service (CFDS), divided by the total cost of the investment.
The cash flow before debt service is equal to the net operating income, or NOI (income minus expenses), less any reserves or expenses for capital improvements. The total cost of the investment is simply the purchase price plus any closing costs (lender fees, brokerage fees, title fees, etc.). The example below illustrates the return on cost calculation. This metric is also called the return on asset (ROA), or un-levered return.
Return on Cost Calculation | |
Effective Gross Income (Less Expenses) Net Operating Income (NOI) (Less Capital Expenses) |
$1,000,000 ($408,000) $1,000,000 ($408,000) |
Cash Flow Before Debt Service (CFDS) Purchase Price Closing Costs |
$590,000 $10,500,000 $210,000 |
Total Cost of Investment | $10,710,000 |
Return on Cost (CFDS/Total Cost) | 5.51% |
Now that we have both our debt constant and return on cost, we can evaluate the impact of the (three) scenarios of debt terms from the previous section on this particular investment.
Recall that in each case, the principal amount was equal to $7.35M, or 70 percent of the $10.5M purchase price. The return on cost is the same under each scenario because the financing or capital structure of the investment does not affect this “un-levered” metric. When the debt constant exceeds the return on cost, that is said to be a negative leverage environment. The converse is true as well. When the return on cost exceeds the debt constant, this creates a positive leverage environment.
Scenario 1 Leverage Evaluation | |
Debt Constant | 5.90% |
Return on Cost | 5.51% |
Leverage | Negative |
Scenario 2 Leverage Evaluation | |
Debt Constant | 7.02% |
Return on Cost | 5.51% |
Leverage | Negative |
Scenario 3 Leverage Evaluation | |
Debt Constant | 4.83% |
Return on Cost | 5.51% |
Leverage | Positive |
It is critical to understand whether you have positive or negative leverage because negative leverage decreases your return on equity (ROE), whereas positive leverage increases your return on equity.
The ROE is the amount of cash you receive as a percent of the cash you invested. That’s why this metric is also known as your cash-on-cash return. In the example outlined above, only scenario three has terms (amortization length and interest rate) that create a positive leverage scenario, therefore, increase the return (ROE) that the investor would receive on their invested capital.
If the investor accepted the terms of the lender in scenarios one or two, their return (ROE) would be worse than if they hadn’t placed debt on the property.
Buyers often use debt because real estate is a capital-intensive investment. It takes a lot of money to get in the game, and most investors do not have the cash available to purchase assets without debt. But it’s critical to understand the impact of proposed terms of the debt so that you can positively impact the overall return on your investment.