Using Leverage to Increase Returns
Today I’m going to talk about the impact of leverage on your rate of return. When it's done properly, it can be a beautiful thing. In this example, we have a 60-unit apartment complex that's valued at $3,725,000. The financing terms are a 4.25% rate with a 30-year amortization, a 75% loan to value ratio, and 1.5 points on the cost. Also in this particular example, the net income on the property is $260,000, which equates to a cap rate of about 7%, because that’s the net income divided by the purchase price. So, now let's figure out what our return is using leverage. Since our down payment is 25%, or $931,250, and the closing costs are estimated to be $41,906, which is 1.5% times the loan amount, the out of pocket in this deal is $973,156. So, what is our rate of return on that money? First, let’s figure out what our debt service is. Based on the financing terms stated above, the annual debt service is $164,923. If you subtract that amount from the net income of $260,000, that’s a before tax cash flow of $95,077. Divide that by the all-in out of pocket amount of $973,156, which equals an almost 10% return. To recap, your rate of return with no debt, which is basically your net income divided by your purchase price, is only 7%. If you use debt with today's terms, or whatever terms it is in the future, you're going to earn 10%, which is a 40% increase in your rate of return by smartly using debt. Now, this is assuming debt is smart in this case. Every case is different. Here it looks like it's logical.
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