A Whole New Way to Look at Leverage

by | BiggerPockets.com

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.

Pop Quiz

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.

  1. What is your cash flow if you pay all cash for the property (no loan)?
  2. What is your cash flow if you put down $0 of the purchase price (get a 100% Loan to Value—aka LTV—loan)?
  3. 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.

Key Data

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.

Related: 3 Powerful Ways to Use Leverage in Real Estate Investing

businesswoman doing paperwork at office desk, working through finances, using calculator and making notes in her notebook with pen

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.

Related: To Leverage or Not to Leverage? Why the Answer Isn’t as Simple as You Think

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? 

Comment below!

About Author

J Scott

24 Comments

  1. kris patel

    Looks like you are using 7% interest @ 30 yrs fix rate. It is hard to get 100% loan. DSCR coverage if 1.20, need 20% down. ( 100K/80K )
    Sometime need to go negative leverage. In my case got a drug store at 7.35 Cap and 0.08 Constant, 4 Million PP and 17% Dn. Loan at 6.11 % Fix for 24 Yrs, fully paid in 24 Yrs. Happy with cash flow. If they renew lease for 50 Yrs after, no payment!
    Estate planning tool, thanks.

    • J Scott

      Just remember, when you have to go negative leverage, you lose more return for every additional dollar you’re borrowing. The more you borrow, the worse the impact on your return (unlike positive leverage). So, when getting negative leverage, make sure not to borrow any more than absolutely needed.

      • kris patel

        In 1031 Exchange, need to buy on what you sold. I went 50% more for two reasons. One was in 2010 could borrow upto 105% of purchase price, second more depreciation. Put down exchange sale proceed, if went 105%, negative cash flow if 3K a month. Thanks

  2. Christopher Jordan

    Maybe this is a fluke but I came up with the same numbers but went a different route.

    1. (I broke everything down into monthly)
    10% cap rate on 1mil=100k annual=8,333.33 monthly
    With paying all cash, thus eliminates principal and interest your cash flow is 8,333.33(100k) or .0833333
    2.10% cap rate on 1mil=100k annual=8,333.33 monthly
    Getting 100% financed–>8333.33(cap rate)-6666.67(Principal and interest)=1666.663333(20K annual cashflow) or .02

    I dont know if I made it more difficult or you made it more scientific, but these numbers work out the same way using basic calculations and math. Cap rate minus expenses will give you cashflow(in laymens terms)

    Right?

    • J Scott

      Not a fluke at all. There are several ways of deriving cash flow, and none is inherently better (or more right) than the others. I was simply doing it in a way that most people haven’t seen before in order to provide some insight into where the cash flow was coming from (leveraged versus unleveraged funds).

      My goal was less to get to the right answer and more to get to the understanding of how leverage works, at it’s very basic implementation (positive versus negative leverage).

  3. Jeff Kehl

    Excellent job explaining this! I’ve tried a few times to explain similar concepts in posts and I always seem to get bogged down in the math and the assumptions.

    These days and particularly a few months ago when interest rates were higher it was amazing to see some of the deals out there particularly from apartment syndicators where the cap rate they were buying at was lower than the interest rate they are paying on the loan.

    Their financial projections all still look good because they are assuming they will be able to raise rents and increase the NOI but at some point that just won’t work any longer.

    Also a subtle point I think people miss is that you’re always essentially borrowing 100% of the purchase price because the downpayment is coming from somewhere either your own capital or investors.

    And the investors are generally going to expect more than the bank in terms of return. So, if you add the investor’s return to the banks interest rate the total cost of capital is often far higher than the going in cap rate.

  4. Tom Knutson

    Interesting method. Can you share how calculating returns with loan constant is better/different than just using the interest rate of a loan? Calculating based on loan payment is helpful but would this be applicable to interest only loans? You’d also want to make sure not to double count taxes and insurance if you’ve got a PITI payment and comparing to NOI. Do you use this method on single family residential or mainly multi-fam/commercial?

    • J Scott

      The loan constant will dictate the impact that the loan has on your capital, not just the simple rate you’re paying. As I’m sure you’d agree, a loan at 6% interest that is fully amortized and paid back over 30 years is going to be a lot more beneficial than a loan at 6% that is fully amortized and paid back over 5 years.

      Even though they have the same interest rate, the second example likely means that you’ll be losing a lot of money every money for the first 5 years. And the second is almost certainly going to generate negative leverage. This is where the loan constant is important — it can allow you to compare two loans to determine which is most beneficial when it comes to your cash flow and capital impact.

      As for whether it’s applicable to interest only loans, for an interest only loan, the loan constant is going to be equal to the interest rate. Which, as that will tell you, is an optimal loan from the perspective of helping your cash flow and having minimal impact on your capital.

      And this can certainly be used for single family, multi-family or any other cash flowing asset (real estate or not).

    • J Scott

      There are plenty of places to get 100% leverage. Buy with a short-term private loan and then refinance 100% of your costs after 6 months with a new appraisal. Buy with 100% seller financing. Buy with Subject To.

      There are plenty of ways to purchase rentals without any/much of your own cash. But, they take work. You can’t just purchase off the MLS or walk into a Wells Fargo and get a conforming loan.

  5. John Daley

    This is an excellent article. I hate debt but love leverage…which, unfortunately, tend to be the same thing. :-O Performing calculations as described in this article can help you find your own personal sweet spot when trying to calculate how much you want to put down (or how much to get out if you’re BRRR-ing). I try to get as much back out while still maintaining a certain level of positive cash flow. Sometimes I can get it all back, sometimes less, sometimes more. A home run is getting more out than you put in while still netting positive cash flow. Difficult to find, but not impossible…

    • J Scott

      John –

      You said:

      “A home run is getting more out than you put in while still netting positive cash flow.”

      That is the definition of positive leverage, and that is the type of leverage we should all be looking for. It boosts your returns. If you’re not able to get everything out without going cash flow negative (whether you actually plan to or not), that’s negative leverage. In that case, the leverage is hurting you returns.

    • J Scott

      Tim –

      Having your $1M free is only part of the equation. How much cash flow are you willing to give up in order to keep that $1M? I think you’d agree that borrowing $1M at 3% interest is a lot different than borrowing $1M at 20% interest. This is where the concept of the loan constant and positive/negative leverage come in.

  6. Brett Nobles

    Good article – one question though. In your 2nd example, you used a $750k loan but had the same 2% leverage constant, however, wouldn’t this constant change since it’s derived from the total sum of monthly payments per year?

    Meaning, if you have $100k loan your monthly payment amount would be different from the payments on a $750k loan. So with each change in loan amount you have to recalculate the leverage constant, right? (Assuming, of course, the terms between both loans are the same).

  7. Brett Nobles

    Good article – one question though. In your 2nd example, you used a $750k loan but had the same 2% leverage constant, however, wouldn’t this constant challenge nge since it’s derived from the total sum of monthly payments per year?

    Meaning, if you have $100k loan your monthly payment amount would be different from the payments on a $750k loan. So with each change in loan amount you have to recalculate the leverage constant, right? (Assuming, of course, the terms between both loans are the same).

    • J Scott

      Hey Brett –

      The loan constant is the total sum of the monthly payments DIVIDED BY THE PRINCIPAL BALANCE.

      So, $100K loan would have 10% of the monthly payments as a $1M loan (with the same terms), but when you divide the monthly payments by the principal amount ($100K is also 10% of $1M), you get the same loan constant.

      Long story short, if the terms of the loan are the same, the loan constant will be the same regardless of whether the loan amount is $1 or one trillion dollars…or anything in between.

      • Mark Zych

        Thanks for this article, J. I enjoy thinking about different ways the math works so that I can understand more quickly and clearly how changes in any deal parameter affect the outcome.

        One question/observation: if the the loan payment is consistent throughout the life of the loan, but the principal balance is being paid down over time, won’t the loan constant grow throughout the life of the loan? How does this factor into your equations at, say, year 10 of the loan. All else being equal, cashflow generated is still the same, but with the higher loan constant, your formula calculates a lower cashflow value. Thoughts?

        Thanks,
        Mark

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