Illustrating the Power of Leverage in Commercial Real Estate

The old saying, “Cash is King” has never been more important than in the current economic conditions we are experiencing.  “OPM” (Other People’s Money) is another popular phrase that every real estate investor should consider utilizing to make every dollar count when entering a transaction.  The lesson from both expressions is to use the power of leverage. The article to follow illustrates how leverage can stretch the dollar to create greater wealth when investing in Real Estate.

The larger the pool of money the larger the investment one can make.  Lenders, equity investors (private and institutional) or individuals can be the vehicle to provide this pool of funds.  One word of caution is the cost of capital relative to the capitalization rate on the project. In the example below I am going to illustrate “The Power of Leverage” by using the same cost of capital, just to keep things simple:

An All Cash Buyer

Let’s assume an investor has $1 million to invest and buys a property that yields a 10% return and the investor pays cash for the investment.   The Net Operating income would equal $100,000 per year.

Dipping in to OPM

Now instead of paying $1 million in cash the investor obtains leverage up to 75% of the investment amount.  In this case that would be a loan of $750,000 and the investor would provide $250,000 in cash.  The cost of capital on the $750,000 for this case is 6%, and when amortized over a 20 year amortization period, the annual debt service on the loan would be $64,478 per year.  The net cash flow to the investor would be $35,522 per year, realizing a 14.2% return on your investment.  This is a 4% increase using leverage.

Now Comes the Fun Part

If you want to get even more creative you can add back in the principal amount you pay on the loan ($20,000-$25,000 each of the first 5 years of the loan) and now the adjusted annualized return equals roughly 22%!  This is more than double the actual return from paying cash for a property.

The initial criterion was to invest the $1 million dollars into real estate. Next, I showed you the benefit of OPM. Now, consider the purchase of multiple properties. If you buy a total of 4 properties and utilize leverage, a total investment of $4 million dollars will be realized versus $1 million paying all cash. 

This leads me to my final thought on leverage and the appreciation of assets.  Granted, today this is non-existent, but over the long term there is an appreciation factor realized.  Let’s assume a 3% appreciation factor for the above investments:  that’s a $120,000 in value per year on a $4 million dollar investment compared to $30,000 per year in value with the all cash example. 

OPM and Cash is King. Two very important expressions when it comes to real estate investing. In remembering the meanings behind the two statements and using the power of leverage, you can turn your good real estate deal into a great one.

Written by: Christopher J. Grobelny of Weston, Inc. a Cleveland Commercial Real Estate company.