Another word for Leverage would be lending. By borrowing between 50-75% of the purchase price, you are able to realize the value of the entire asset’s growth without using your money.
This is a really simple concept that people often take for granted but it’s crucial to realize the power of this phenomenon. You can purchase larger assets thus providing economies of scale, greater risk adjusted returns, and faster growth. The table below illustrates the power of growth if you invest $100,000 and all things are equal except leverage*. The difference in actual cash returned is compelling.
|Equity Invested||Property Acquired||Free Cash Flow (5 Yrs)||Yr 5 Sale @ +5%/Yr||Total Earnings + Initial Return of Capital (not Shown)||Internal Rate of Return|
|35% Down/65% Leverage||$100K||$285,714||$85k||$171,429||$157,143||22%|
*Conservative Assumptions of 6% Cap Rate, 6% Interest Only loan for a 5 yr hold period and 5% annual increase in property value.
Commercial real estate is valued based on Net Operating Income (think of it as all profits before any debt service). Since everyone’s debt terms, amounts, and needs are different, the industry has created a Cap Rate to compare apples to apples. It is the rate of return if an asset were owned and paid for in all cash. In essence, the value expresses the rate of return the property yields each year. So a 10% cap rate means it would yield 10% cash each year if owned free and clear. Or said another way, it would take 10 years to make your money back. Cap Rates are inverse of growth. When they compress or decrease, the asset’s actual value is increasing and when they expand or become larger, the property is decreasing in value. It’s counterintuitive for sure and often trips people up as they learn this concept.
Leverage also has an economic impact many investors tend to ignore. When you are a passive investor, you receive economic benefit from the leverage of other’s work product, experience, skill and networks. This benefit cannot be stressed enough. Imagine trying to run a $2-5M side business while also performing at the high level you do in your current role. The leverage of people, time and resources is truly invaluable. Leverage keeps you from going at it alone.
In the example above, the $100,000 spread is only possible via leverage. In combining your investment with like-minded others, you can realize the same scale. Let’s discuss the next benefit.