The Perfect Use of Leverage

Posted by Lapp Realty Commercial Group on Wednesday, January 3rd, 2018 at 2:21pm.

As a self-proclaimed entrepreneur, I get excited about new projects and ideas. Entrepreneurs need new challenges and constant progression forward. Sitting still is not an option for many entrepreneurs, as the feeling of getting passed by the competition eats away at you.

But how can you keep growing with only a finite amount of personal capital and personal time? Leverage.  As an entrepreneur, there are two forms of leverage.

There is financial leverage and human resource leverage. In both cases, too much reliance on either of these two things can create volatility and risk, while not enough leverage will ultimately limit your capacity to grow.

Today let’s have a look at the results of utilizing financial leverage in the acquisition of a commercial investment property.

The Prospective Investment:

Building Price: $1,000,000

Net Rental Income: $80,000

Conservative Scenario #1: Cash Purchase 

Building Purchase Price: $1,000,000

Mortgage: $0.00

Down Payment: $1,000,000

Return on Invested Capital (ROIC): 8% per year (+/-)

Semi-Conservative Scenario #2: 50% Equity; 50% Mortgage

Building Purchase Price: $1,000,000

Mortgage: $500,000

20 Years @ 3.75%

Payments: $35,482.92 / Year

Principal Pay down: $17,168.59 / Year

Down Payment: $500,000

Return on Invested Capital (ROIC): 12.33% per year (+/-)

ROIC Result is a cash on cash return of $44,517/Year with equity pay down of $17,168.59 resulting in a total return of $61,685/Year.

Leveraged Scenario #3: 20% Equity; 80% Mortgage

Building Purchase Price: $1,000,000

Mortgage: $800,000

Payments: $56,772.72 / Year

Principal Pay down: $27,469.78 / Year

Down Payment: $200,000

Return on Invested Capital (ROIC): 25% per year (+/-)

ROIC Result is a cash on cash return of $23,227/Year with equity pay down of $27,469.78 resulting in a total return of $50,697/Year.

The entrepreneur in you might say, LETS BORROW AS CLOSE AS WE CAN TO 100% LOAN TO VALUE!?!?! IMAGINE THE RETURNS!??

You guessed it, here comes the counter point of leverage and the association with volatility. Notwithstanding that no bank would ever lend you 100% Loan to Value on real estate unless you have an extremely strong equity position on your balance sheet, let’s have a look at a few things.

The Higher your leverage position, the more your volatility is magnified.  You owe more against the property and your payments are higher.

As a result of this, you are impacted by smaller adjustments and unforeseen future circumstances. Are you going to need to spend money on repairs to the building in the future? What if you lose a tenant and go six or even eight months with a vacant building? What then? If interest rates increase at your mortgage renewal, guess what happens to your payments? Yup, they go up as a result of more interest on your leveraged asset.

Let us not forget economic forces such as a reduction in market lease rates, guess what happens to the value of your building. Yup, down she goes.

Then, with a reduction in lease income, you may very well be left with a Debt Service Coverage of less than 1:1.  That’s what we call a deficit (which isn’t good).

However, by utilizing leverage in the examples above, my return on invested capital increases and at the same time allows me to leverage my remaining capital against a second building and even have some cash I the account to cushion any changes in the market or loss of tenants.

This is the balancing act. This is what you need to consider when you are searching for your own perfect leverage point.

There is no question that every investor and entrepreneur is different depending on their individual goals, risk tolerance and age.

Leverage, however, when used responsibly can help you achieve better returns on your capital, more growth potential and most importantly for the serial entrepreneur in us, keep you actively moving forward into new projects.

What is your view on financial leverage?

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