Earning Positive Leverage

Home Earning Positive Leverage

This is some serious nerd stuff right here so look away now if you aren’t interested. I wanted to do a quick spreadsheet on what the cap rate spread needs to be, above the lending rate, in order to get positive leverage (or benefits) from the loan. In other words, given certain loan terms you see today (LTV, interest rate, and amo period), at what cap rate do you need to buy at in order to increase your returns? Obviously the answer varies depending on the loan terms but I can tell you roughly speaking it varies from 1.75% to 3.35% depending on your required cash on cash return (rate of return on your equity after operating expenses and debt is paid).

See the chart below and if you want the spreadsheet so you can mess around with it to plug in different numbers just let me know and I can email it to you. While I know that some investors can borrow for lower than 4.25%, I used that as a base. I also used 70% LTV as the base but obviously you can see other LTVs below. I also created a separate column and used 8.00% cash on cash return as a “goal” return since that is usually a reasonable middle ground for investors, although some investors accept less and some need more.

For example, what the chart says is that if you have a 4.25% interest rate, with a 30 year amo, and borrowing at 70% LTV, you can’t have any less than a 6.0% cap rate before you start to lose return by accepting that loan. At that level the cash on cash return is marginal at 6.23% but still better than the 6.00% cap rate as if you didn’t get leverage at all. Now if you need at least an 8.00% cash on cash return, then given the same loan terms you need to have no less than a 6.55% cap rate (2.30% spread).

Another example is if you had a 20 year amo, 4.25% rate, 30 year amo, then you’d need at least a 7.50% cap rate to make the loan work. We all know finding a true 7.50% cap rate buying apartments today is nearly impossible. Likewise, an investor who would seek a 20 year amo for apartments is nearly impossible.

I’d say for most investors today though using more aggressive 4.0% rates the spread typically needs to be between 2.00 and 2.50 points to earn reasonable cash on cash returns. Depending on the investor, that spread can either be something that needs to be in place prior to purchasing (much more difficult in today’s market) or have the ability to achieve that spread within some reasonable time after closing via value add efforts.

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