Impact of Leverage on Cash-on-Cash Returns
In the spirit of truly understanding some important concepts behind investing decisions many of us are making, I wouldn't to start this thread...
Basically, I was surprised at the information I'm about to provide (I did this analysis in another thread a couple days ago and got some unexpected results), and figured a couple of you may be surprised as well. At least for me, it will impact some decisions I make down the road...
Assume a rental property that generates 2% of its cost in monthly rent and that operates at a 50% expense ratio (actually, expenses + rent loss + capex). Further, assume the property is leveraged somewhere between 0% (all-cash, no leverage) and 100% (fully leveraged at all-in acquisition cost).
The following graph plots two curves -- one representing a typical conventional loan amortization/rate and the other representing a typical portfolio loan amortization/rate -- with leverage amount indicated on the X-axis and it's resulting cash-on-cash return indicated on the Y-axis:
What I see in this graph:
- Below 60% leverage, CoC is basically flat, without much opportunity for leverage to impact CoC, regardless of type of loan
- Between 60-80% leverage, amortization/rate of the loan will determine whether you can start to increase your CoC or not
- Above 80%, any positive leverage will greatly increase your CoC, but the amortization/rate will play a HUGE role in the extent of the increase
The key takeaway for me is that, for lower amounts of leverage, conventional versus portfolio loans make no difference -- and, in fact, leverage doesn't make much of a difference at all. For medium amounts of leverage (60-80%), there is a big difference in CoC based on type of loan chosen. And for larger amounts of leverage, both loan choices are good, but conventional terms/rates are very beneficial.
There are some obvious implications here (for me, at least) in terms of:
- Whether I would even want to leverage at lower percentages, given the paperwork, DTI hit and loan costs
- What types of loans I would pursue based on the amount of leverage available
- The value of using the small amount of conventional loans available to their best advantage
Anyway, thought the results were interesting, and thought I would post them...enjoy!
