Real estate investors can boost their cash-on-cash returns using reasonable leverage. Positive leverage involves an investment strategy in which the return rate on the cash invested is higher than the cost of capital on borrowed funds.
This article will explain the fundamentals of positive leverage when applied by investors of residential real estate. Experienced and successful investors know how to manage the use of borrowed funds when acquiring and renovating their value-add properties.
Key Takeaways
- LTVs are lower under a traditional loan, meaning a higher percentage of investor equity is required
- The benefits of high-leveraged loans are building equity, increasing returns, tax benefits, and diversification
- The returns are higher when less cash is invested over a short period
- All investors must be able to recognize the distinction between positive and negative leverage
- Levered IRR (Internal Rate of Return) must be higher than the unlevered IRR for the leverage to be positive
Defined Terms
- Positive Leverage – the amount of a return on the cash is higher than the cost of capital
- Loan-to-Value (LTV) Ratio – the ratio between the amount of a loan relative to the property’s market value
- Levered IRR – measures the effects of borrowed funds
- Unlevered IRR – measures the hypothetical scenario of all cash
Investors have financing options to consider for higher-leveraged loans. These loans will benefit the investor by increasing their investment opportunities and earning a higher return on their leveraged cash. The risks with a high-leveraged loan involve timing and knowing the market.
The Use of Leverage by Investors
A common strategy is to acquire a value-add property from a motivated seller and create value through renovations and upgrades. The value created by the renovations must exceed the cost of acquiring and renovating the property.
If an investor seeks a traditional loan, meaning from a regulated bank or credit union, the loan-to-value (LTV) ratio will be lower, and the costs of the renovation scope will need to be funded by investor equity, meaning cash. Traditional lenders are not competitive when the LTVs are compared. This, of course, is assuming the loan will be approved.
Investors find that their cash-on-cash returns are lower because too much of their cash is invested in too short of time. The leverage will become negative if the investor has the fix-and-flip objective.
Traditional loans are structured for properties with the value and the cash flow in place over a long-term hold. This scenario is the best use of these leveraged funds. Time is the investor’s friend.
Private lenders are bullish on lending on value-add properties over a short-term hold. These lenders strive to meet an investor’s objectives and offer varying loan structures to consider.
Even when an investor has the buy-and-hold objective, there must be an opportunity to “churn” the equity dollars created. When an investor can access this equity, the down payment for the next investment is often funded. Ownership remains in place for the investor to enjoy the cash flow generated from the property.
This is positive leverage at its best.
Benefits of Financing with High Leverage
A high-leveraged loan will maximize the liquidity position of an investor by requiring less cash invested. The less cash needed to invest will allow for other opportunities. In other words, an investor can do more with the same amount of cash.
The other benefits of using high-leveraged loans are:
- building equity
- increasing returns
- tax benefits, and
- diversifying the portfolio.
1. Building Equity
Equity can be built in either the fix-and-flip or the buy-and-hold strategies. Equity is the difference between a property’s market value and the balance remaining due on the mortgage.
Equity is built as the loan is paid down over time. Value is created by the improvements made to the property over the short term and from trends in the market over the long term. Equity and value are created in either strategy.
2. Increasing Investment Returns
A high-leveraged loan will increase the probability of higher returns. However, these are short-term loans with higher rates and carry costs. Time is not the investor’s friend.
An experienced investor knows when to refinance a short-term loan with permanent money. If timed right, the return on the equity will be exponentially higher than with a low-leveraged loan over the time hold period.
3. Tax Benefits
There are tax benefits when financing a rental property with a high-leveraged loan. The property’s operating expenses, property taxes, and mortgage interest can be deducted from the collected rents to lower the taxable net income. The non-cash deduction of depreciation will also reduce the taxable income.
However, to gain the maximum tax benefit, the investment must be held for more than one year, meaning one year plus one day. This one-year and one-day hold period will categorize the investment as long term when capital gains are used to calculate the taxes owed on the sale proceeds.
The tax rates on capital gains are scaled from 0%, 15%, and 20%. Investment properties held over for one year or less, are categorized as short-term. The gains realized from the sale are defined as ordinary income and taxed at the rate commensurate with the investor’s tax bracket.
4. Diversification
As explained earlier in this article, when an investor has more opportunities with the same amount of cash, additional investments will diversify the portfolio. Diversified holdings are the best way for an investor to hedge against concentration risk in, for example, a property and/or in an are
Financing Options
The options for real estate investors to consider are given and explained below. These options include high- and low-leveraged loans and the investment phase for these options to achieve maximum returns for the investor.
Hard-Money Loans
Private lenders offering hard-money loans are the best choice for the investor to acquire and fund the renovation scope. Private lenders use the value to be created in their underwriting as opposed to the purchase price, or the property’s cost.
The rates and the fees will be higher to reflect the risk measured for the value to be created and for the market to support the projected value to maintain positive leverage. The private lender is a short-term investor much like its borrower with a fix-and-flip objective.
Hard-money loans are also the best choice for the investor with a long-term buy-and-hold strategy. The parameters of the acquisition and renovation remain, but instead of the investor selling the property at a profit, the hard-money loan is refinanced with long-term permanent money.
The return on the cash invested over the short term is the same under either objective. The qualification for a hard-money loan is the lender’s risk measurement and the investor’s experience and liquidity.
DSCR Loans
Private lenders offer DSCR (debt service coverage ratio) loans as an alternative to traditional, long-term permanent loans. DSCR loans are for stabilized properties where the value is created, a tenant is in place, and the property generates sufficient cash to be self-sustaining. This is the definition of a stabilized property.
If the property has a DSCR of 1.2 or above, then this is the main qualifier for this loan to be competitive. The investor’s liquidity is a factor should the property become vacant during the loan term. The credit score is the determining factor of the quoted interest rate.
The formula to calculate a property’s DSCR is:
- Rental Income ÷ PITIA (i.e. Principal, Interest, Taxes, Insurance, and Association Fee)
As an example, if a property generates $14,400 over one year, and the loan payments during the same period totals $12,000, then the DSCR calculates to 1.20x, or
- $14,400 ÷ $12,000 = 1.20x
From this example, the interpretation of this 1.20x coverage ratio is, for every $1 of debt service, the property generates $1.20.
To qualify for a DSCR loan, the investor will not be required to produce tax returns or any evidence of wages or other income, which is a compelling convenience factor for investors.
The fact that the debt-to-income ratio is not imposed comes across as favorable to investors and shows that the sky is the limit on loans as long as each deal makes sense.
Traditional Loans
Traditional lenders, meaning banks, credit unions and other credit facilities insured by the FDIC, offer loans to acquire or refinance hard-money loans when a property stabilizes. In either scenario, the property must be stabilized and the value in place.
A traditional lender may lend on a value-add opportunity, but the loan ratio will be based on the cost, or the purchase price.
The underwriting process will not give consideration to the projected value (i.e. ARV) created by any renovation or upgrade, and the costs of the renovation will need to be funded by the investor’s cash. The qualification standards are relatively rigorous.
These loans are structured for the long term with a lock-out period. During this period, the loan cannot be refinanced or satisfied, A typical lock-out period is three years. After this period, there may be a pre-payment penalty phased out over five years.
These periods are put into place by traditional lenders to ensure a certain amount of cash flow over a specific time.
Investors will not have access to any accumulated equity during these periods. Although the rates and fees will be lower than what will be quoted by a private lender, the access to these funds will be negated for a much longer period.
The Private Lender
Often, residential real estate investors are uncomfortable with the loan structures offered by private lenders because they know of the higher rates and carry costs. The loan terms are not affirmatively stated on their websites.
This is because each loan is tailored to the transaction, the investor’s objective, and the measurement of risk.
The underwriting of a private lender is flexible because it is subject to the lender’s entrepreneurial spirit and not federal requirements.
A private lender will meet the investor’s objectives for the acquisition, renovation, and the permanent money refinancing. A private lender is the best option for the investor who wants to keep as much of their cash as possible, and to have the lender look at the merits of a deal as the main factors of underwriting and qualification.
The Best Investment Strategy
A high-leveraged loan comes with the potential for higher returns and higher losses. The use of these loans cannot be taken lightly.
An investor needs a healthy combination of risk tolerance and confidence. Proformas must be prepared conservatively with realistic goals.
Before a high-leveraged loan is sought, the levered and the unlevered IRRs must be calculated. The levered IRR measures the effect of the borrower funds. The unlevered IRR calculates the return under the hypothetical condition of no debt.
The simple formula for calculating an IRR is:
- Levered Return: Net cash flow ÷ Proceeds after loan satisfaction
- Unlevered Return: NOI ÷ Proceeds after expenses
The difference between levered and unlevered returns is the expenses. The cash flow is used when calculating a levered return. Cash flow considers all expenses and financial obligations. The value is the remaining proceeds after the loan is satisfied. The unlevered return uses the NOI, or the remaining amount before any financial obligations are met. The value is the remaining proceeds after expenses without the loan satisfaction.
The levered IRR must be higher than the unlevered IRR in order to affirm the positive effect of leverage.
Financial leverage creates opportunity. Experienced investors understand how to time the satisfaction of a high-leveraged loan to create optimum returns. Although time is not the investor’s friend, the returns will be higher when less cash is invested over a shorter period.
Investors new to the real estate investment world need to get comfortable with leverage and how to recognize positive leverage before entering into any leveraged position.
