New to This Industry and Trying to Understand RE Better
Hey Everyone,
I am new to this industry and I am trying to understand how it works. I have a couple questions below
1) Conceptually, why does leverage increase IRR of a deal?
2) Why is it the case that in a low interest rate environment, cap rates also decrease?
When you add leverage, the amount of equity required in the deal is reduced, increasing your return of equity. Debt is also cheaper than your equity generally, meaning that your returns are amplified.
There always is a spread between the cap rate and the risk-free rate. If the risk free rate decreases, the cap rate of a market generally decreases as well to maintain that spread. This is because investor will tolerate a lower cap rate.
Thanks for helping me out. Just two follow-up questions:
1) In question 1, how do you know that equity contributes $1m? I understand how you get $2.6 million, as that is levered cash flow
2) For question 2, I still don't understand why an investor would tolerate a lower cap rate. Could you expand upon what you mean by that?
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