Leverage Can Boost Equity Yield
Here’s one example of how returns can be greatly improved by knowing when to incorporate a loan.
When examining investment property as commercial real estate professionals, we are looking to buy future cash flow. We’re buying the potential income and assuming the risk that comes with it. It’s as simple as that.
In this piece, we’re going to talk about equity yield and how properly using leverage can greatly impact yields. Let’s look at a case study to see how these issues play out.
Detailing the Initial Investment
An investor is looking for a property where he’s willing to invest $6.75 million of equity if the annual return is 10 percent. He plans to own the property for five years and wants it to be in a strong, growing market.
We found him a proposed apartment complex in Austin, Texas, with 60 units. We want to be sure this is a stable property based on market rents and occupancy. The project, including land and construction costs, comes in at $6.5 million. Acquisition costs are 2 percent, so the total initial investment is $6.63 million. After five years, we predict disposition costs are 5 percent.
But before selling this property, we want to increase income by 3 percent a year. Laundry machines will provide another $4,000 in revenue with 2 percent annual increases. Expenses will run 40 percent of gross operating income, with an average vacancy rate of 5 percent and average replacement reserves at $250 per unit per year.
Data courtesy of TheAnalystPRO
We next need to predict our future sales price. In order to calculate both the property yield and our equity yield, we must consider the future reversion, or sale, of the property. For income properties such as this, analysts and appraisers will use the income method
using cap rate. For this case study, we will predict the disposition cap rate at 7.5 percent.
(As a disclaimer, predicting future cap rates can be very speculative. Several factors need to be considered, including cap rate trends from both historical and current cap rates, as well as cost of capital and future supply and demand in a particular market.)
With all these figures in place, what does this mean for your investor? Projecting out five years in the chart below, you can see that cash flow before taxes steadily rises from $500,400 in the first year to $564,984 in Year 5. That’s a nice chunk of change, but your investor was
looking for 10 percent annual return. In Year 5, when income is at its highest, the cash-on-cash return is only 8.52 percent.
Exploring Other Options
But once your investor sells the property after five years, he will bring in another $936,750 above the purchase price. With this, along with the cash flow, the annual property yield (IRR) of the investment reaches 10.28 percent.
Let’s look at other options for this investment — namely how a loan could turbocharge returns. Let’s say the investor could get a loan for 80 percent of the apartment complex at 5 percent. (Based on the current 10-year Treasury rate, this is on the high side.) The
bank will get 1 percent with 25-year amortization and a 10-year term.
The initial investment drops considerably, from $6.63 million to $1.482 million. But the overall return more than doubles, to 23.39 percent.
The chart below has three columns showing how a proposed deal changes with a loan. The first outlines the deal without financing, including an upfront investment of $6.63 million. The cash flow meets your investor’s requirements, while the property IRR remains the same
regardless of financing. The second represents the annual financing cash flow, which includes the initial loan proceeds, annual debt service, and the final loan balance repayment in Year 5 of $4.97 million. The last column shows the investment with the 80 percent loan — this represents your money.
As you can see, using financing more than doubled the property IRR/yield for an equity return of 23.39 percent annually, an increase of 13.11 percent from the 10.28 percent property IRR. By making the most of available financing, you’ve positioned your client to more than surpass the initial goals for this multifamily development, while reducing the necessary upfront investment.
With positive leverage, you can boost the equity yield, literally doubling the returns for your client.
As an experienced, knowledgeable commercial real estate professional, you want to be able to deliver this kind of value add to your clients. In this case, you have a cash buyer with the funds to cover the $6 million-plus investment. But with positive leverage, you can boost the equity yield, literally doubling the returns for your client.
Editor's note: This article was adapted from “Cap Rate and Rent Setting: Analyzing a Proposed Development,” Kuhlmann’s presentation at the 2019 CCIM Global Conference in San Diego, presented with Karl Landreneau, CCIM.
For more on this topic, check out CCIM Institute's
“Before and After Tax Discounted Cash Flow Analysis” course.