To continue with my example from a prior Builder’s Corner, entitled Leverage, I want to discuss a concept called negative leverage. 
The last edition example was as follows:
Example: An investor is debating purchasing a 1,000,000 dollar asset that produces a cash flow of 100,000 annually. Should he take his 1MM dollars and buy the thing 100% cash free and clear. If he pursued this avenue he would achieve a 10% return on his equity 100M/1MM. 10% nowadays seems like an attractive deal, but what if the investor withholds 800M and only invests 200M. The other 800M to acquire the property is obtained via a loan from a bank. The bank’s nowadays may not loan this much but let’s continue with the example. This 800M dollar loan is at a rate of 7% annually which translates into a total payment of 67,850.80 per year. So to get to the crux of the matter you take in 100M a year from your property and dish out 67,850.80 to the bank. Your remaining proceeds are 32,149.20. This means an annual return of 32,149.20/200M which is a 16.07% return on your equity which far exceeds the all cash purchase of the property.
BUT… what if times are tough (such as 2009) and things take a turn for the worse? Hypothetically one or two of your tenants who you are negotiating leases with (who are partial contributors to your 100,000 annual cash flow) come to you and want a rent reduction. You concede due to your need to maintain a certain synergy and occupancy of the center high and reduce landlord non-reimbursable operating expenses. Then the bank comes back to you and says they can only structure a deal at 7.25% interest rates as their underwriting has tightened up. As a result, the new scenario is that your center has a cash flow of 85,000 annually. If you bought the building for 1,000,000 then your return on equity would be 8.5%. If you choose to take the 800,000 dollar loan from the bank and use leverage then your annual debt obligation will be $69,389.46. So if you choose to use debt in this situation you are left with a (cash flow after financing) of 85,000-69,389.46 which equals 15,610.54. This CFAF divided by the 200,000 in equity you dished is a return on equity of 7.8%. As you can see in this example you are better off purchasing the center with all equity than with debt. The higher bank rates go up the bigger your annual debt obligation and the smaller your CFAF.
Until next week!
Cheers,
John
Similar Posts:
- Builders Corner – The Benefits of Leverage
- Builder’s Corner: Phantom Income
- Builders Corner: Financing Out
