I wanted to touch on the concept of using debt in real estate investing by giving examples of an investment using all equity, a mixture of equity and debt, and an overview of debt instruments which are available to the average investor.
If you are interested in one day acquiring real estate as an investment, the contents of this post can shed some light on the benefits of using debt as part of your financing structure.
Using debt alone to finance a real estate investment can over-expose you to default risk.
In other words, using a lot of debt to finance an investment will result in large debt payments which the property’s net income may be unable to service, resulting in default.
Technically speaking, financial leverage is the benefit of borrowing other people’s money at an interest rate that is lower than the expected rate of return of your investment.
When there is positive financial leverage (expected return is greater than the rate of borrowing), you can be certain that the return on your equity invested will be amplified.
As a rule of thumb, whenever financial leverage is positive, the more leverage you use, the higher your returns on equity will be.
There are other implicit benefits of using debt to finance your real estate investments. Namely, you may not have enough equity to purchase your property all-cash.
In this case, using debt will be necessary in order to make the investment. Second, using debt to finance a real estate property will result in a mortgage payment consisting of your interest payment and your principal payment.
A mortgage allows you to take advantage of the ‘tax-shield’ provided by interest payments given that they are tax deductible.
Combine the tax-shield provided by interest payments with the tax benefits of depreciation deductions and you have yourself a potent recipe for magnifying your return on equity invested and keeping more of it.
Using debt to finance your real estate investments results in these benefits:
- Allows you to make investments that wouldn’t be possible with your own equity, or gives you the flexibility to diversify your equity in other investments rather than investing it all in one;
- Provides a tax-shield from the interest payment portion of the mortgage; and
- Magnifies your returns on equity invested when there is positive financial leverage.
An example will help us quantify the benefits of using financial leverage. I will use the example from last month’s post on residential investing
and modify it to include taxes paid to the federal government.
Two further assumptions were made here:
1. The standard depreciation rate used on Residential rental properties is 27.5 years and is calculated using straight line depreciation ($100,000 ÷ 27.5) and
2. A tax rate of 35% on Taxable Income (Taxable Income = NOI – Depreciation – Interest Payments)
To arrive at the actual Tax paid, take your Taxable Income and multiply by your assumed Tax Rate of 35%. In this example, $2,611 of your cash flow is going to taxes, leaving you with a Cash Flow After Taxes of $8,485.
For simplicity, we will not make an assumption for a Capital Gains Tax, which would be a tax on the gains realized from the sale of your real estate property.
In order to arrive at Cash Flow From Sale, you simply aggregate Cash Flow After Taxes and all line items below it.
Purchasing this property using all equity allows you to realize an IRR of 7.63% after a 5 year hold, with Cash-on-Cash Yields of 11.10%. Now let’s examine what your returns would look like using debt.
For this example, we make some simple debt assumptions:
1. We use a Loan-to-Value (LTV) of 60%, meaning that you only have to contribute 40% equity, as opposed to 100% in the previous example. To be specific, LTV = Loan Amount ÷ Acquisition Price. Taking 60% of the Acquisition Price, the Loan Amount is equal to $60,000;
2. The Loan is a 30 year Fixed-Rate Mortgage (FRM), which is a fully amortizing loan whose interest rate remains fixed throughout the life of the loan (as opposed to an Adjustable-Rate Mortgage); and
3. The Interest Rate on the loan is 6%.
Cash Flow Before Taxes
Let’s focus on comparing Cash Flow Before Taxes:
Since no leverage was used in the all equity acquisition, there were no debt obligations that needed to be met by your net operating income.
For this reason, your Cash Flow Before Taxes for your all equity acquisition is higher than your Cash Flow Before Taxes when using leverage.
When we look at our Cash-on-Cash yields, however, a different story about returns unfolds.
In the all equity acquisition, $100,000 was required of you to make the purchase. When you take the ratio of how much cash flow the property is producing and the amount of equity required to purchase that property, the yield realized is 11.10%. On the other hand, the acquisition using leverage only required an equity contribution of $40,000.
Although the Cash Flow Before Taxes of $6,779 is lower than the all equity Cash Flow of $11,096 – the yield is considerably higher. The difference in yields is a result of the magnification caused by using financial leverage.
Remember from the formula above that Taxable Income is NOI, less Interest Payments and Depreciation. In the example using debt, your Taxable Income is less than your Taxable Income from an all equity investment by the Interest Payment amount.
By using leverage, the amount of your Net Operating Income that is eligible as Taxable Income is reduced by depreciation and then further reduced by the interest payments on the loan you took out to acquire the property.
This results in a lower Taxable Income that can be taxed at the assumed 35% tax rate. In other words, the tax-shield we discussed earlier activates, allowing you to keep more of your cash flow.
Internal Rate of Return
Your Internal Rate of Return (IRR) is your average annual return that you can expect to receive over a certain amount of time, given a corresponding amount of cash flows.
Let’s see if using leverage in our example succeeded in magnifying your returns:
The 5 year hold of your all equity acquisition yielded an IRR of 7.63% while your acquisition using leverage yielded 13.16%. The difference in returns is directly attributable to the benefits of financial leverage.
It is instructive to note that both of these examples used the same income, operating expense, tax, and sales assumptions. The only difference was that one used a combination of debt and equity to acquire the property, while the other used all equity.
I do not want to get overly technical here, but earlier in the post I mentioned that the benefits of using financial leverage arise when the expected return of the investment is greater than the rate at which you are borrowing.
The expected return of the investment is equivalent to our ‘all equity IRR’ of 7.63% while the cost of borrowing is equal to your loan interest rate of 6%.
The positive financial leverage occurs precisely because the all equity IRR is greater than the interest rate paid on the debt.
Had the IRR on the all equity investment been greater than 6% (the rate at which you’re borrowing) negative financial leverage would have occurred.
Types of Real Estate Debt Instruments
Now that you have seen some of the conditions necessary for debt and financial leverage to work in your favor, let’s discuss some of the common debt instruments that an average investor can potentially use:
- Fixed-Rate Mortgages (FRMs) – a fully amortizing mortgage loan whereby the interest rate at which you borrow at remains fixed throughout the life of the loan;
- Adjustable-Rate Mortgages (ARMs) – a mortgage loan whereby the interest rate will adjust periodically according to a pre-specified index (ie. LIBOR);
- Interest-Only Mortgage – a mortgage loan in which the borrower is responsible for paying only the interest portion on the principal for a predetermined term with the principal to be paid via a balloon payment at maturity.
The outcome of your decision to use debt as part of your real estate financing structure results in positive (favorable) financial leverage, or negative (unfavorable) financial leverage depends entirely on the due diligence performed by you, the investor.
Financial leverage carries inherent risks and the more debt you use to finance an investment, the larger the risk becomes.
Perform proper and extensive due diligence, and the benefits of positive financial leverage will certainly boost your real estate returns.