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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   January 2008

When Leverage is a Thing of Beauty

A simple conversation could open your clients' eyes about their property investments

When Leverage is a Thing of Beauty

Each investment comes with a certain return. For you and your clients, the goal is for those returns to be positive.

In times of tightening credit, however, loans seem harder to obtain. And investors who do obtain bank loans must come to the table with more equity than in recent years.

As a service to your clients, you might consider showing them how different levels of leverage can affect their investment return. It’s a fairly simple concept, but it never hurts to explain it to them or remind them of some basic principles. Sometimes, this explanation can enlighten even the most-hardened investors. 

When it comes to financing real estate, there are two basic methods — unleveraged and leveraged. For the purposes of this article, leverage refers to debt on real estate or loans used to acquire, refinance or develop real estate. Let’s take a closer look.

Unleveraged

In an unleveraged transaction, your clients finance a property or business with only cash, and they use no debt. If they are acquiring an apartment building with a purchase price of $100,000 for example, they bring $100,000 in cash to the closing table.

By paying all cash, they’re using no leverage, which means no loan payments. In the case of income-producing properties, this usually results in greater cash flow.

A disadvantage to this method is that borrowers must hand over significant cash upfront. Rarely are investors in the position to have enough equity capital to buy a property. This is the main reason people often use the leveraged method of financing property instead.

Leveraged

Most lenders offer financing so borrowers can acquire property with a small percentage of the total purchase price as a downpayment. In this way, borrowers use a small amount of cash to leverage property that has a much greater value than the amount of money they’re investing.

Your property-investor clients might know what leverage is but not how it can make them more profit. The answer: By using debt to finance property, they’re already making higher returns than they realize. Using leverage correctly can increase their profit potential in any given real estate transaction.

It’s all in the numbers. Use the following basic illustrations to explain to your clients the potential outcome they could see with either scenario.

The all-cash option

To keep things simple, assume the following:

  • The property has a purchase price of $250,000.
  • The property returns $25,000 per year in cash flow after expenses.
  • You’ve reviewed income and expense documents and verified the net operating income (NOI).
  • Your clients’ tax bracket is 28 percent.
  • Depreciation is calculated in a straight line over 31.5 years on the value attributed to the building only. 
  • The building value is 85 percent of the purchase price, or $212,500. 
  • The land value is $37,500 and is not depreciated. 
  • The investment horizon for this project is five years, after which your clients plan to sell the property.

With this information, you can show your clients what their expected return would be if they used all cash to purchase the property. Do this by preparing a simple pro forma analyzing income and debt over the course of the expected hold period.

Start by looking at the initial downpayment, which is equal to the purchase price. Next, consider before-tax cash flow, which equals the debt subtracted from NOI. In this case, debt is $0, so the before-tax cash flow is $25,000.

To figure out taxable income, subtract the loan interest and depreciation from the NOI. That number is then multiplied by your tax rate. In this case, based on the assumptions above, tax is $5,111 — ($25,000 - $0 - $6,746) x 28 percent.

After-tax cash flow is a more precise representation of how much cash flow comes back to your clients from the operation of this property. Calculate it by subtracting the tax amount from the before-tax cash flow. In this case, after-tax cash flow is $19,889 — $25,000 - $5,111.

This property will therefore return $19,889 per year to your clients for the time that they hold the property. Their goal is that in the fifth year, when they sell the property, they will have realized some appreciation. But for the sake of keeping the numbers simple, assume they sell in the fifth year for the same price at which they bought the property.

Accounting for tax and depreciation, figure out the actual profit from the sale. This number, combined with the cash flow from each year of operation, will help you determine the internal rate of return on the property. The internal rate of return is the interest rate at which the investment’s net present value is zero. This, in turn, determines the rate at which your client’s money was returned over the investment period.

The property was depreciated $6,746 per year, or a total of $33,730 during the holding period. That number is subtracted from the original purchase price to figure out the adjusted basis upon which the capital gains will be based. Capital gains are the difference between final selling price and the adjusted basis.

Here, the adjusted basis is $216,270 — $250,000 - $33,730. Capital gains equal $33,730. This number is taxed at your client’s tax rate, which is $9,444.

The profit from the sale is figured out by subtracting the tax paid on the sale from the sale price. In this case, the profit from sale is $240,556 — $250,000 - $9,444.

Therefore, the developers will have made $19,889 in each of the five years of operation plus $240,556 from the sale of the property.

To figure out your clients’ return on their investment, you can determine the formula for internal rate of return (IRR). Taking into account the initial cash downpayment, the annual cash flow each year over five years and the final profit from sale, the IRR on this property is 7.3 percent.

That means after the investors account for tax on their investment, they can expect to earn a rate of return equal to 7.3 percent by using all cash to buy this property.

The debt option

Now, let’s see how using debt can affect the rate of return. Assume the same property fundamentals as those from the previous example.

Now assume you’ve identified a bank willing to lend your clients 80 percent of the purchase price at an interest rate of 8 percent for 30 years, interest only. Their downpayment is therefore 20 percent of purchase price, or $50,000. They’re borrowing $200,000, which means yearly debt payments of $16,000.

Before-tax cash flow is $9,000 — $25,000 - $16,000. Tax will be reduced because your clients can write off interest paid on the loan. Tax equals NOI minus interest paid minus depreciation multiplied by the tax bracket. Based on the property assumptions, tax is $631.

Because interest can be written off investment properties, there is a tax savings when your clients use leverage. After-tax cash flow equals $8,369 — $9,000 - $631. That is what your clients will receive each year in cash flow from this property.

The sale price in the fifth year is the same, but now the borrowers have to pay off the debt on the property, which is $200,000. The before-tax profit from sale is then $50,000 — $250,000 - $200,000.  Capital gain is the same as the previous example because the adjusted basis is the same — $9,444. Therefore, the after-tax profit from sale is $40,556.

Your clients will earn $8,369 per year in positive cash flow and $40,556 from the sale of the property in the fifth year. The cash flow and final profit are less than in the first example, but your clients only put $50,000 as a downpayment. This was significantly less than if they had paid all cash. Further, they tied up less risk and less money over time.

The internal rate of return is 13.9 percent to your clients in five years. By using leverage and investing less money upfront, your borrowers almost double their rate of return.

The unleveraged return of 7.3 percent isn’t bad. It beats putting money in a savings account or CD. The leveraged return of 13.9 percent is better, though.

Ultimately, a direct result of using less money to acquire a property can be increased returns. Further, your clients can free up cash for other investments. This may be important to people who spread their investments across multiple properties and those who want less upfront risk.

If the worst-case scenario comes true and the property is lost, the investors would lose only $50,000 as opposed to $250,000. One drawback to keep in mind with leverage, however, is that if the buyers were to sell the property at a loss, their IRR would be less than if they had used all cash.

•  •  •

Many investors believe they are better off using their own money to finance real estate, especially development projects. They don’t want the hassle of dealing with draws or bank managers or writing checks to lenders.

By using these examples, however, you can illustrate how leverage can be used to help them keep more cash in their pocket and increase overall investment return. Even the most-stubborn investors can appreciate a higher return, and you may gain some new clients.

Disclaimer: This article is intended for educational and informational purposes only and should not be interpreted as financial advice. Advise your clients to consult a certified public accountant for their specific situations. 


 


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