Listen up, buy and hold investors and math geeks. This one’s for you.
How well do you understand leverage? For those only somewhat familiar, there’s a super cool finance concept that I think will make you look at leverage in a completely different way.
To begin, let’s test how much you know already.
Before getting to the quiz, here’s some context.
You’re planning to buy a property for $1,000,000 that has a 10 percent cap rate. This means that if you purchase the property in cash, you’ll generate 10 percent of the purchase price each year in net operating income (NOI).
If you were to get a fully amortized loan against the property for $1,000,000, your payment (principal and interest) would be $6,666.67 per month.
For the questions below, assume that we define cash flow as NOI minus debt service.
- What is your cash flow if you pay all cash for the property (no loan)?
- What is your cash flow if you put down $0 of the purchase price (get a 100% Loan to Value—aka LTV—loan)?
- What is the general method or formula to determine your cash flow for any other LTV between 0 to 100% on this deal?
There are several ways of generating the answers to these questions. But I want to help you understand where your cash flow is actually coming from, not just the amount. Once you get a grasp on that, you’ll think about leverage a whole lot differently moving forward!
So again, specific answers here are much less important than the methodology.
We need three pieces of data to calculate the answers.
- Cap Rate of the Investment: As outlined above, the cap rate for this investment property is 10 percent.
- Loan Constant of the Loan: If you’re not familiar with the loan constant, it’s a ratio used in finance to signify the relationship between a loan and the payments on that loan. Before financial calculators and computers, the loan constant was used to easily determine the monthly payment on a loan. The loan constant can be calculated by taking the total loan payments for a given year and dividing it by the principal balance of the loan. In our example, we have monthly loan payments of $6,666.67 per month, which is $80,000 per year. And the initial loan balance is $1,000,000. Therefore, the loan constant for this loan would be:
Loan Constant = $80,000 / $1,000,000 = .08 (or 8.0%)
- Our Leverage: In this case, we use the term Leverage (with a capital L) to indicate the return we are either earning or losing on the capital we’re borrowing with this loan. (Confused yet? Just stick with me.) Leverage is defined as the cap rate minus the loan constant.
Leverage = 10% – 8% = 2%
With this data, we have enough information to answer the three quiz questions, as well as the ability to quickly determine the cash flow for any loan scenario involving this specific property and this specific loan.
Answers and Explanations
Cap rate applies to any down payment you make, regardless of whether it’s 100% of the purchase price or not.
By now you probably know that if you were to purchase a property with no loan, you can use the cap rate to determine the NOI (which is the same as our cash flow if there’s no loan). Here’s the formula.
Price * Cap Rate = NOI
In this case, if we purchase the property for $1MM in cash and our cap rate is 10%, our NOI is going to be:
$1,000,000 * 10% = $100,000
So, for question No. 1, the answer is $100,000.
But what you might not realize is that this cap rate will apply to any cash you contribute to the purchase of the property, even if it’s not the full $1MM.
For example, let’s say you made a down payment of 50 percent of the purchase price ($500,000) and got the other $500,000 from the lender. Your cash flow on this $500,000 down payment follows the same rule as above.
$500,000 * 10% = $50,000
In this case, the $500,000 down payment on this property will generate $50,000 per year in cash flow. (Keep this in mind. We’ll come back to it later.)
Leverage applies to any borrowed money you receive from the loan.
Now, what about the borrowed funds? Borrowed funds are going to be either working for you (generating additional cash flow) or against you (taking cash flow away).
When borrowed funds generate extra cash flow, it’s called positive leverage. With positive leverage, borrowing money actually increases returns.
When borrowed funds reduce cash flow, it’s called negative leverage. With negative leverage, borrowing money decreases returns.
So, how do you know if you’re getting positive or negative leverage? And how much positive or negative leverage are you getting exactly?
This is where the “Leverage” value calculated above comes in. If the value is positive, you have positive leverage. If it’s negative, you have negative. The percentage calculated indicates exactly how much additional return you’re getting (or losing) on those borrowed funds.
Think of it this way.
The cap rate tells you how much the property is earning. The loan constant tells you how much the borrowed funds are generating in returns for the lender.
In this example, the property has a cap rate of 10 percent, so the property is earning 10 percent. But the loan constant is 8 percent, which is what the lender takes from our 10 percent cap rate in exchange for lending us the funds.
The cap rate is higher than the loan constant, so the lender isn’t taking all the returns, just 8 percent of the 10 percent. Therefore, the leftover 2 percent is additional profit the borrower earns on the funds they were lent.
To reiterate, if the cap rate is higher than the loan constant, the difference between the two is extra return for you to keep! If the loan constant is higher than the cap rate, the lender is absorbing all of the return (the entire cap rate), plus more! As a result, your returns will be lower.
Going back to the scenario above, the Leverage value is 2 percent. This is good news. It translates to positive leverage of 2 percent. For every dollar borrowed, you would get 2 percent extra return on it every year in cash flow.
Let’s say you get a 100 percent LTV loan on this property—in other words, borrow the full $1,000,000 purchase price using the loan previously described. With a 2 percent return on every dollar borrowed using this loan on this property, calculate your yearly cash flow like this:
Borrowed Amount * Leverage = Cash Flow on Borrowed Funds
$1,000,000 * 2% = $20,000
Answering quiz question No. 2, if you borrow $1,000,000 against this property and put $0 down, the annual cash flow will still be $20,000.
That’s the power of positive leverage! Even at 100 percent LTV, you’d still be making money.
To determine total cash flow on both unleveraged and leveraged funds, use this simple formula.
Let’s go back to our example of making a 50 percent down payment and getting a loan for 50 percent. As previously mentioned, cash flow on the $500,000 down payment is going to be $50,000. But what about cash flow on the $500,000 in borrowed funds?
All borrowed funds are generating 2 percent returns, so:
Cash Flow on Borrowed Funds = $500,000 * 2% = $10,000
Total cash flow should equal the cash flow generated on the cash we’re putting in ($50,000) plus the cash flow being generated on the cash we’re borrowing ($10,000). Thus, total cash flow using a 50 percent LTV loan would be $60,000, as illustrated below.
You should be able to substitute any other combination of down payment and borrowed funds to determine your annual cash flow in the same manner.
For instance, if you put 25 percent down ($250,000) and got a loan for $750,000, your cash flow would be $40,000.
Did you follow that? Pretty cool, right?!
Instead of just figuring out the cash flow on a deal (which can be done in several ways), you can now see exactly where it’s coming from and whether the cash flow from a loan is generating positive or negative leverage. From there, you can determine whether this loan is actually helping you or hurting you—and by how much!
If I lost you somewhere, I suggest re-reading. It took me a while when I first learned it, as well.
Do you have any questions?