The math behind what we do

|

At this point in the cycle, when we consider a new deal, we spend a lot of time thinking about leverage.

Mainly, we’re looking at how our pro forma unlevered yield (eg the cap rate we’re trying to hit post renovation) compares to the projected interest rate on the refinance we’ll do at that point.

I know this is a little boring, but stay with me!

Let’s look at three scenarios, all $5MM all-in deals.

Scenario 1: 7% unlevered yield

  • Invest $5MM
  • Hit 7% unlevered, so $350k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $7.8MM (divide $350k by 4.5%)
  • Borrow 65% LTV at 4.5%
  • That’s a $5.1MM loan, with annual debt service of $309k
  • So, we’ve got all the money invested back out of the deal and we’re earning $350k-309k = $41k / year
  • Levered yield of $41k / $0 = Infinity!

Scenario 2: 6.25% unlevered yield

  • Invest $5MM
  • Hit 6.25% unlevered, so $313k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $7.0MM (divide $313k by 4.5%)
  • Try to borrow 65% LTV at 4.5%, but can’t, because the NOI won’t exceed the debt service by enough to make the banks (or us!) comfortable
  • Instead, borrow $4.3MM (61% LTV), with debt service of $260k
  • Leave $5MM-$4.3MM = $700k in the deal
  • Receive free cashflow 0f $313k-260k = $53k
  • Levered yield of $53k / $700k = 7.6%

Scenario 3: 5.75% unlevered yield

  • Invest $5MM
  • Limp into a 5.75% unlevered, so $288k in Net Operating Income
  • Building appraised at a 4.5% cap, implying value of $6.4MM
  • Borrow $3.95MM (ouch), with debt service of $239k
  • Leave $5MM-$3.95MM = $1.05MM in the deal
  • Receive free cashflow 0f $288k-239k = $49k
  • Levered yield of $49k / $1.05MM = 4.7%

As you can see, in Scenarios 1 & 2, the more you borrow, the better the deal gets. That’s because the unlevered yield exceeds the cost of the debt (which is the total debt service divided by the loan amount). In Scenario 3, because the cost of the debt exceeds the unlevered yield, the more you borrow, the worse the deal gets.

The above is, in a nutshell, why our business exists. We get paid to deliver unlevered yields that are in excess of the cost of the debt, allowing investors to benefit from leverage, rather than get killed by it.

Share