How Leverage Impacts Your Return On Investment (ROI)

Leverage is the concept of using other people's money in this lesson I'm going to show you three different examples of investing in the same $ million asset at an 8% cap rate one with no leverage one with 50% leverage and one with 75% leverage to highlight the impact on the investor returns a good way to demonstrate this is to think of the cash that is generated by the property in this case the $80,000 of noi going into a bucket with the the investor using no leverage they get to keep all of the cash in the bucket in this case they invested $1 million and are getting a cash return of $80,000 each year for an 8% cash on cash return so when we think about leverage think about it as partnering with the bank but at a lower cost in this case with the 50% Leverage The Debt Service on a $500,000 loan would be $30,000 per year that equals a 6% cash return the lender's loan constant the lender's portion is only 30,000 the remainder goes to the investor the investor keeps 50,000 of the 80,000 and since they invested 500,000 of their own cash that yields a 10% cash on cash return in this last example at 75% leverage the lender is putting up $750,000 of the capital in the form of debt and the investor only puts up $250,000 in cash at that same rate in terms once again that $45,000 divided by the 750 is a 6% cash return to the lender the lender's loan constant that leaves $35,000 in the form of net cash flow left over for the investor the investor only puts up in this case $250,000 of their own cash $35,000 divided by $250,000 investment is a 14% cash on cash return the investor is only putting up 1/4 of the amount of capital and they're making a significantly higher return on that Capital this is called positive leverage and effectively positive leverage occurs when the cap rate is greater than the loan constant now the loan constant can change as you've seen in other lessons depending on the interest rate and the amortization but whenever you have a spread between the cap rate and the loan constant where the cap rate is higher it's typically optimal to increase leverage in order to increase the Investor's cash on cash return the example I just showed you was an inst of what we call positive leverage where the return to the lender or the loan constant is lower than the cap rate allowing the investor to capture some of that net cash flow to increase their return there's also what's called neutral leverage where the lender loan constant is the same as the cap rate therefore not providing any additional benefit to the investor for leveraging other than reducing the amount of capital they need to invest to acquire the asset and then of course we have what's called negative leverage and that's when the loan constant is higher than the cap rate in that case the investor needs to Forfeit additional cash flow to service the debt where the lender is making a higher return in order to analyze the optimal amount of Leverage to use simply compare the loan constant and the cap rate if the cap rate is higher than the loan constant then use more leverage to increase the cash on cash return if the loan constant is higher than the cap rate then less Leverage is better in order to optimize cash on cash return

Channel: Real Estate Finance Academy | Trevor Calton

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Keywords: real estate investing, real estate investing for beginners, real estate investing strategies, real estate, leverage, investing, cash flow, financial education, graham stephan, biggerpockets, bigger pockets, interest rates, real estate market, commercial real estate investing, real estate leverage, real estate leverage explained, real estate investing leverage, Loan Constant, real estate loan constant, cash on cash return real estate, cap rate, return on investment real estate

Id: 8QplNAC9RPI

Length: 3min 32sec (212 seconds)

Published: Sun Jun 05 2022