All Forum Posts by: Joe Latson

Thanks @Jeffrey Donis!

Leverage, when used as a noun, refers to a ratio of the amount of debt (loan capital) to the value of the equity (cash or balance sheet equivalent). For example, if an investment, let’s say a property, has $100K of debt and has a total value of $150K (implying $50K of equity value), then the leverage ratio is $100K / $50K or 2:1. You could also say that there is 66.7% leverage ($50K / $150K).

An investment is said to have positive leverage when the interest rate on the debt is lower than the unlevered yield on an investment. This relationship causes the levered yield to be higher.

Sophisticated investors are most concerned with maximizing their risk-adjusted returns. They want to generate the highest possible returns relative to a quantified level of risk. Utilizing leverage is an extremely effective means to increase returns while intentionally dialing up the risk. If the name of the game was ONLY about getting the highest returns without regard for risk, there are plenty of casinos in Las Vegas who would happily take the other side of that trade.

Negative leverage occurs when the interest rate is higher than the unlevered yield, and as a result the levered yield is lower than the unlevered yield – in other words – the leverage is dilutive to returns. What’s happening in situations like this is that the debt investors are being compensated more than the equity investors, despite taking less risk.

Leverage impact on cash flow yields

Let’s look at an example to show the impact of leverage in action. We’ll use the $240K property above, and assume it generates $12K in annual net operating income, resulting in a 5% unlevered yield ($12K ÷ $240K).

The table below illustrates how the levered yield changes based on the interest rates that are less than, equal to, and greater than the unlevered yield. You can see how the leverage magnifies the returns in either direction.

To further emphasize the point, the figures below were adjusted to assume 90% leverage (up from 75%) and the resulting Levered Yields were magnified even further; up from 8% to 14% and down from 2% to -4%.

Despite the seemingly abundant headlines about institutions diving head first into the single family housing market, they only control only 2% – 3% of single family rentals. The majority of rentals are owned by small companies and individuals. To contrast, +45% of apartments are owned by institutional capital. That is an indicator for how much room there is for the single family industry to further institutionalize.

There has been institutional presence in the single family housing market since the 2008 housing crash, after which private equity giant Blackstone helped fund Invitation Homes. Invitation Homes (INVH) is now the largest owner of single family rental properties in the country with +80K homes. (Note, Blackstone divested their INVH position in 2019; it is currently an independent publicly-traded REIT.)

However, until recently, examples of institutional investors targeting single family housing have not been all that common. This is primarily because it is notoriously difficult to scale, relative to both capital deployment and ongoing operations.

For example, it is harder to invest $200M into individual single family homes than it is to build a single $200M condo building. From an operating perspective, the condo building only has one roof to maintain while a $200M portfolio of houses could have 700!

That said, the current consumer demand story is too powerful for institutions to ignore. And there is a burgeoning ecosystem of start-ups and other technology companies creating efficiencies that weren’t possible before.

There are a number of long-term demographic trends in place that support a single family housing investment strategy.

• There is a massive undersupply in housing caused by decades of under-building; Freddie Mac estimates the US has a shortage of over 4M housing units.
• Millennials are growing their families which is causing them to seek out more living space, yards, and better school districts – all difficult boxes to check in a multifamily setting.
• Younger generations increasingly value access over ownership. Many of them want the flexibility of renting; they are more mobile than their parents either by choice or necessity, and experience more frequent job changes.
• For those that do want to own, for many reasons it remains difficult to qualify for a traditional mortgage – especially for gig economy workers or those that have heavy student debt burdens.

These trends all became more pronounced during the Covid-19 pandemic. Additionally, the newfound ability for many individuals to work from home further increased demand for single family housing as people seek to optimize their living environments.

Combine all that with the fact that during 2020, national single family rents grew by 3.8%, while multifamily saw a 0.8% decline – and the result is that institutional capital has collectively decided that single family is an asset class that deserves a slice of the Asset Allocation pie chart.

Institutional investors are a professional class of organizations that manage large sums of “institutional capital” (money), such as pension funds, university endowments, insurance companies, sovereign wealth funds, or family offices.

For example, CalSTRS is a pension fund that provides retirement benefits for California’s public school teachers. They are also an institutional investor. As of May 31, 2021, they are responsible for investing $307 Billion of assets under management (AUM) on behalf of their pension.

All pensions, CalSTRS included, do more than just working with their members to provide pension benefits. CalSTRS is also an investment manager of all of the money that they are responsible for, and their investing employees’ primary role is to perform a function called Asset Allocation.

Asset Allocation means to deploy capital using a diversified investment strategy. To do this, they set targets for how much capital is dedicated to each asset class. They base their allocation targets on historical risk and return profiles, as well as high-level macroeconomic trends and forecasts.

CalSTRS target Asset Allocation is reflected below:

Within each asset class, there is further diversification. For instance, within real estate you can diversify across geographies (domestic vs. international), product types (office vs. residential) and strategy (acquisitions vs. development).

Institutional capital is by no means an expert in all of these various domains, so they partner with professional investment managers who specialize in specific sectors and strategies. CalSTRS real estate allocation is managed by over a dozen firms, including Blackstone, Invesco (partnered with Mynd), Divco (partnered with Atlas), Blackrock, Fortress and JP Morgan.

Effects on the Real Estate Market

Institutional capital flows are noteworthy because when investors adjust their target Asset Allocations, it can result in huge sums of money flooding into a sector simultaneously.

For example, CalSTRS decided 14% of their capital should be invested in real estate. As of May 31, 2021, their actual real estate allocation was only ~12%. To bridge the 2% gap, CalSTRS needs to increase its real estate exposure by $6.1B!

This is an example of just one pension fund. There are hundreds of investment managers making allocation decisions, and Institutional investors are known for operating with a “herd mentality” – they tend to copy their peers’ strategies.

Think about this: the 100 largest pension funds collectively manage ~$18T. If they decide to increase their exposure to real estate, or specifically residential housing, by just 1%, they would be mandated to acquire $186B worth of housing units.

Using an average home price of ~$285K, they would need to acquire over 650K homes to hit their allocation targets! These are huge numbers – to put it in perspective, according to the US Census, the City of Austin, TX has ~400K households.

Takeaway

This phenomenon of capital flooding into a sector is especially notable if it is happening for the first time – which is what we are seeing in single family housing, particularly rentals.

To effectively deploy billions of dollars into a sector for the first time, especially one as nuanced and fragmented as housing, new technologies and operating models must be invented and executed with expert precision. These innovations create opportunities for those paying attention.

Thanks @Jeffrey Donis and @Cameron Tope! Hope it helps and always happy to answer any Q's re: finance and strategy. 

Have a happy 4th of July!

@Cameron Tope that is a great question! I hope that this answer is helpful, it borders a ramble as there are a lot of situational and strategic drivers that could alter course. 

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As part of determining the optimal capital structure for a particular investment, investors should compare both the unlevered and levered investment returns. This illustrates the benefits of using leverage, which need to be weighed against associated risks.

Typically, if you are in growth mode I would recommend up to 75% LTV so long as you have positive leverage. Positive leverage is when your cost of capital is less than the returns generated from the cashflow of the property.

For example: Interest rate for long-term rental property = 4.5% and your unlevered yield (NOI / Cost Basis) is 5.5%, you have positive leverage.

By utilizing more leverage while you are growing, you can invest your equity across more properties in a shorter period of time. 

As your assets appreciate, your LTV will decrease as a result of the appreciation.

For example: Total cost basis at acquisition = $400k and you get a loan for $300k. This = 75% LTV. Two years later, the property appraises for $450k. Your $300k loan is now 67% LTV.

At this time, you may also decide to refinance out of your initial loan. The reasons to do this would be to either "cash out" or because interest rates have moved in a favorable direction. To cash out means to pull equity out of the deal by refinancing. 

For example: Total cost basis at acquisition = $400k and you get a loan for $300k. This = 75% LTV. Two years later, the property appraises for $450k. You refinance at 75% LTV. The new loan amount is $337.5k. You just cashed out $37.5K.

People do this because the IRS doesn't view the money you take from a cash-out refinance as income – instead, it's considered an additional loan. You don't need to include the cash from your refinance as income when you file your taxes.

You will want to make sure to account for any prepayment penalties at that time, too. Depending on the penalty, if at all, will impact the economics of your refinance. Most lenders will have a step down in prepay penalties over the life of the loan. Common to see 5/4/3/2/1/par or 3/2/1/par, etc. 

Re: Preservation/Protection mode. My personal opinion is that the value of leverage is really dependent on the state of the capital markets... i.e. where are interest rates and is debt working for me or against me? At 75% LTV, the chances of your property decreasing in value 25% or more is pretty low. However, it's not impossible.

I used to represent some large institutional investors in the commercial real estate world. Generally, those investors did not go beyond 60% LTV. The reason being that they weren't seeking the highest rate yields and the cost of capital correlates to the amount of leverage on your asset. Lower leverage = less risk = lower cost of capital.

So, if you are in a stage where you have hit your growth goal and just want to kick back (no such thing as an owner IMO, LOL) and cash flow, it could totally make sense to start refinancing out of your acquisition loans (remaining principal, no or very little cash out) and benefit from the increased cash flow as a result of a lower interest rate loan at a lower LTV than when you purchased the property.

From there, as you keep buying, you might have the equity to start only using debt up to 50% - 60% LTV and the amount of cash you generate suffices your goals and needs!

Hey BP! 

Hope this is helpful for some and happy to dive in more re: the right capital structure for different types of business plans and investors. 

Thank you!

What is Capital Structure?

The way an investment or entity is owned and funded is referred to as its capital structure, or “cap stack” for short. One might ask, “how is this investment capitalized?”.

Broadly speaking, the capital stack consists of two components – debt and equity. Debt is effectively a loan to the investment entity, which most commonly comes from a bank or specialty-lender, but also includes other types of financing like a HELOC or even a credit card. Equity represents ownership in the investment. As such, the equity investors retain “control” of the investment and make major decisions, so long as they remain in compliance with the loan documents.

Investors use debt (sometimes called ‘financing’ or ‘credit’) because it can lead to higher investment returns on their equity and helps stretch their investable dollars further. The amount of debt incorporated into a capital stack is commonly referred to as leverage.

Debt investors benefit from a repayment priority and typically have the ability to foreclose on the collateral if the borrower defaults, therefore it is not as risky an investment as the investment of the equity investors. For that reason, equity investors demand higher returns than debt investors.

All Equity vs. Levered

Let’s say you have $60K of cash to invest in a property.

One option would be to acquire a $60K property. However there are a handful of reasons why that might not be the best option. In that scenario the capital stack would be 100% equity.

Another option is to finance a portion of the investment with debt. With moderate leverage incorporated into the capital stack, say 75%, you can afford a $240K property. Here the capital stack is 25% equity and 75% debt. You would still own 100% of the asset while only investing 25% of the required cash.

Takeaway

Like anything, it gets more complicated from here – there are many types of debt and many types of equity that are useful to understand after you grasp the basics.

The correct takeaway here is that leverage can be a powerful tool.

• It can be used by investors to enhance returns by intentionally introducing a quantifiable amount of risk.
• It allows investors to take on more or larger deals than they would otherwise be able to if limited to their readily available cash.

However, if not used responsibly, or if luck is not in your favor and the market suddenly turns against you, leverage can quickly erode returns and even worse, result in a complete loss of investment.

The way an investment or entity is owned and funded is referred to as its capital structure, or “cap stack” for short. One might ask, “how is this investment capitalized?”.

Broadly speaking, the capital stack consists of two components – debt and equity. Debt is effectively a loan to the investment entity, which most commonly comes from a bank or specialty-lender, but also includes other types of financing like a HELOC or even a credit card. Equity represents ownership in the investment. As such, the equity investors retain “control” of the investment and make major decisions, so long as they remain in compliance with the loan documents.

Investors use debt (sometimes called ‘financing’ or ‘credit’) because it can lead to higher investment returns on their equity and helps stretch their investable dollars further. The amount of debt incorporated into a capital stack is commonly referred to as leverage.

Debt investors benefit from a repayment priority and typically have the ability to foreclose on the collateral if the borrower defaults, therefore it is not as risky an investment as the investment of the equity investors. For that reason, equity investors demand higher returns than debt investors.

All Equity vs. Levered

Let’s say you have $60K of cash to invest in a property.

One option would be to acquire a $60K property. However there are a handful of reasons why that might not be the best option. In that scenario the capital stack would be 100% equity.

Another option is to finance a portion of the investment with debt. With moderate leverage incorporated into the capital stack, say 75%, you can afford a $240K property. Here the capital stack is 25% equity and 75% debt. You would still own 100% of the asset while only investing 25% of the required cash.

Takeaway

Like anything, it gets more complicated from here – there are many types of debt and many types of equity that are useful to understand after you grasp the basics. 

The correct takeaway here is that leverage can be a powerful tool.

• It can be used by investors to enhance returns by intentionally introducing a quantifiable amount of risk.
• It allows investors to take on more or larger deals than they would otherwise be able to if limited to their readily available cash.

However, if not used responsibly, or if luck is not in your favor and the market suddenly turns against you, leverage can quickly erode returns and even worse, result in a complete loss of investment.

Copy @Royce Wright Jr!

Apologies. Leveraging a primary residence as a tool to secure cheap capital from place to place or as a way to get a HELOC to roll into investments is attractive for sure. Also comes with some pretty real risks and inconveniences.

You could put the money you have saved for a down payment in a "primary" residence into an investment property instead.

I own my home and am constantly second guessing if its the best place to have so much equity. I have a family so that certainty of being able to stay there is important, but I don't think it's the best place to have that amount of cash from a return on capital perspective. Could easily spread that out over a few smaller investments and be more diversified while generating greater returns.

Lots of ways to create your entry and growth trajectory. Good luck! Hope some of this was helpful in one way or another.

Cheers,

Joe

Hey @Royce Wright Jr, 

Private Capital is a good option for value-add type opportunities with anticipated hold periods less than 12 months. The cost of capital is higher than a bank and there will still be reasonable liquidity and guarantee requirements. 

If you are looking more for cash flowing rental properties, there are also some lenders out there that can do long-term loans (5 to 30-year terms) with 30-year amortization and interest only options. They can even be inline with traditional bank or agency pricing and with much less red tape (no tax returns required and don't look at debt to income). 

It's how a lot of people start and then also scale their business. Be careful who you go down that path with though.