Leverage
is the use of borrowed money. The concept of positive
and negative leverage helps clarify decisions about
financing.
Positive
leverage occurs when borrowing increases the return on the
investors equity. When cash-on-cash return (also called the equity
dividend rate) is greater with financing than without, positive leverage
exists. That is, the rate of return on the investor's equity is greater
if the investor borrows part of the property cost than if the investor
pays all cash for it. This usually occurs when the property is earning a
return at a greater rate than the cost of borrowing money.
Negative
leverage occurs when cash-on-cash return is less with financing
than without. Such a situation occurs when the cost of borrowing money
is greater than the rate at which the property is earning a return.
Loan
Constant
A Loan Constant
is the percentage of the loan balance that is needed to pay principal
and interest annually.
Loan Constant
(K%) = Annual Debt Service ÷ Amount of Loan × 100
When computing loans, it is not
necessary to compute the cash-on-cash rate for each loan. The
loan constant (k) and the
free-and-clear rate of return can be compared as
follows:
|
Positive Leverage |
Loan Constant
(K%) |
< |
*Free-and Clear Rate
of Return |
|
Negative Leverage |
Loan Constant
(K%) |
> |
*Free-and Clear Rate
of Return |
|
No
Leverage |
Loan Constant
(K%) |
= |
*Free-and Clear Rate
of Return |
Example:
|
VARIABLES |
No
Financing
Free-and-Clear |
30-year,
9.25% loan |
25-year, 11% loan |
25-year,
9.5% loan |
|
Cost of
Property |
793,000 |
793,000 |
793,000 |
793,000 |
|
- Loan
Amount |
0 |
637,500 |
637,500 |
637,500 |
|
Equity
Investment |
793,000 |
155,500 |
155,500 |
155,500 |
| |
|
|
|
|
|
Net
Operating Income |
83,000 |
83,000 |
83,000 |
83,000 |
|
- Debt
Service |
0 |
- 62,935 |
- 74,975 |
-66,838 |
|
Cash Flow |
83,000 |
20,065 |
8,021 |
16,162 |
| |
|
|
|
|
*Free-and-Clear
Rate
*Cash-on-Cash Rate |
10.47% |
12.90% |
5.16% |
10.39% |
|
Loan
Constant (k) |
n/a |
9.87% |
11.76% |
10.48% |
|
Leverage: |
N/A |
Positive
K%<FCRATE
9.87<10.47 |
Negative
K%>FCRATE
11.76>10.47 |
Neutral
K%=FCRATE
10.48≈10.47 |
|
Financing Decision: |
? |
Borrow Money |
Pay Cash |
? |
The return
in dollars is greater when a property is owned free-and-clear*
(Cash Flow $83,000) than when it is financed ($20,065, $8,021, and
$16,162), but the initial investment ($793,000) on
free-and-clear* is much higher than when it is financed. The
capital of $793,000 which could be making money if invested elsewhere is
tied up as equity in the property owned free-and-clear*.
Therefore, most investor's main concern is the rate of return
they receive on their cash invested (the cash-on-cash rate). In the
example above the highest
cash-on-cash rate (12.90%) is when the property is
financed with $637,000, 30-year, 9.25% loan.
* The
free-and-clear rate of return is the name commonly used for the
cash-on-cash rate of a property which is owned outright (no financing).
Cash-on-Cash Rate (COC%) = Cash Flow ÷ Equity Investment
Free-and-Clear Rate = Net Operating Income ÷ Cost of Property
Disclaimer: Information and interactive calculators are made available to you as self-help tools for your independent use and are not intended to provide investment advice. We can not and do not guarantee their applicability or accuracy in regards to your
individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.
Leverage
Effects Financing Calculator. Decisions about Financing.
