How leverage (debt) magnifies outcomes

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You heard me say in numerous pieces that leverage (debt) magnifies outcomes. What do I mean by that?

Well, let’s examine two identical fourplexes with different capitalization structures. First, here are the operating details:

  • Acquired for $600,000
  • Annual rents of $60,000
  • Assume costs of 35% or $21,000
  • Annual Net operating income (rents minus expenses but not including mortgage payments) of $39,000 / year
The only difference between the fourplexes is the capitalization (how their owners paid for them):
Owner A:
  • Owner A bought all cash / no debt
  • Put down $600,000
  • Now collects $39,000 / year before taxes (6.5% return on cash)
Owner B:
  • Owner B put down 5% ($30,000), borrowed the rest
  • Mortgage of $570,000 fixed for 30 years at 4.5%
  • Monthly mortgage payments of $2,888, or annual payment of $34,656
  • Owner B collects $39,000 – $34,656 = $4,344 / year, a return on cash of $4,344 / $30,000 = 14% cash-on-cash
  • Plus the owner retires $7,634 worth of mortgage debt in the first year (this increases over time)
  • So Owner B gets $4,344 + $7,634 = $11,978 on his investment of $30,000, equating to an overall return of 40%(!!)

Right away, you can see one of the benefits of leverage: The Owner B is getting a 40% return on his money, while the owner in Cap A is only getting 6.5%. So, assuming nothing changes or goes wrong, Owner B is getting a better deal than Owner A.

Scenario 1: The Market Goes Up

Now, let’s look at what happens if the market goes up 20%:

  • Owner A’s property is now worth $600k x 20% = $120k more. Obviously, he’s made 20% on his money.
  • Owner A’s property is also worth $120k more. But he only invested $30k. So his $30k is now worth $150k, an increase of 500%.
So the leverage has magnified the outcome of the market improving for Owner B.

Scenario 2: Rents Drop

But let’s also take a look at what happens in the event the economy turns sour and rents decline by 15%:

  • Owner A is not great, but ok. His rents are down from $60k to $51,000. His expenses are still at $21,000, so he’s netting $30k. He still owns the building and he can hang on to it until the economy comes back around.
  • Owner B is in trouble. His rents are down to $51k as well, so his NOI has fallend from $39,000 to $30,000 (just like Owner A). But he has to make annual mortgage payments of $34,656. Uh oh… Owner B can’t pay his mortgage and defaults (unless he has other money to make up the difference). His initial $30k is gone. Clearly, all that leverage made a bad situation much worse.
So, again, the leverage has magnified the outcome of the rental market tanking for Owner B.

(Incidentally: Can Scenario 2 happen? You bet. It happened to me at Reno St., which we bought in 2008. We were getting $1,200 for 1 beds and $1,000 for studios. At the depths of the 2008-9 recession, we were getting $1,000 for 1 beds and $850 for studios. What saved us is that we had put down 30% on the building. So while it lost value, it never stopped paying the mortgage and cash-flowing.)

So why FHA?

Given the above, why do I generally advise my clients to use FHA mortgages to put as little as 5% down on apartment buildings? Well, I’m looking at context. Here’s my reasoning:

  • Prices are low right now and will increase over time. We just went through a major market crash, so you have to expect that prices will recover, if not immediately, then over the medium term. The larger the asset you buy, the more you’ll benefit (and leverage lets you buy a bigger asset than if you had to use all cash.)
  • Interest rates are cheap. If you’re ever going to borrow to buy an asset, now’s a pretty cheap time to do it.
  • The economy is generally improving and expected to continue improving. Demand for apartments is very strongly linked to employment. More jobs = higher rents, assuming supply stays flat.
  • Not much new supply. Very few new apartment projects broke-ground over the last few years, so there is little new supply coming on line for the next few year.
Smart investors make aggressive bets when they believe the odds strongly favor them. Right now, I think the odds favor increasing rents and property values. So the more you buy, and the more highly-levered you are, the better I think you’ll do. Could I be wrong? Absolutely. But I’m long real estate with leverage in my own life, too. So, if you follow my advice, we’re riding this particular train together.

 

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