Leverage is the concept of using other people's money.
Specifically, in real estate, leverage means using bank debt, thereby reducing the amount of capital or equity that the investor needs to come up with in order to do the acquisition. In this lesson, I'm going to show you three different examples of investing in the same $1,000,000 asset at an 8% cap rate - one with no leverage, one with 50% leverage, and one with 75% leverage, to highlight the impact on the investor's returns.
A good way to demonstrate this is to think of the cash that is generated by the property, in this case the $80,000 of NOI, as going into a bucket, and with the investor using no leverage, they get to keep all of the cash in the bucket. In this case, they invested $1,000,000 and are getting a cash return of $80,000 each year, for an 8% cash on cash return.
So when we think about leverage, think about it as partnering with the bank, but at a lower cost. In this case, with the 50% leverage the investor is effectively partnering with the lender, but the lender's cost of funds is lower. The debt service on a $500,000 loan at 4.5% percent amortized over 30 years would be $30,000 per year. The $30,000 debt service divided by the $500,000 outlay in the form of a loan that the bank made equals a 6% cash return, or the lender's loan constant. Well, if the lender's portion is only $30,000 out of the $80,000, then the remainder goes to the investor in the form of net cash flow. The investor keeps $50,000 of the $80,000. And since they invested $500,000 of their own cash, that yields a 10% cash on cash return.
Now let's see what happens at 75% leverage. At 75% leverage, the lender is putting up $750,000 of the capital in the form of debt, and the investor puts up $250,000 in cash. At that same rate, in terms 4.5% amortized over 30 years, the debt service on that $750,000 is $45,000 per year. Once again, that $45,000 divided by the $750,000 is a 6% cash return to the lender, the lender's loan constant. That leaves $35,000 in the form of net cash flow left over for the investor. The investor only puts up, in this case, $250,000 of their own cash; $35,000 divided by a $250,000 investment is a 14% cash-on-cash return. In this case, the investor is only putting up 1/4 of the amount of capital and they're making a significantly higher return on that capital.
This is called positive leverage. And effectively, positive leverage occurs when the cap rate is greater than the loan constant. Now, the loan constant can change, depending on the interest rate and the amortization. But whenever you have a spread between the cap rate and the loan constant, where the cap rate is higher, it's typically optimal to increase leverage in order to increase the investor's cash on cash return.