Positive leverage financing
I had the understanding that leverage always helped improve cash on cash returns so long as the interest paid was less than the unlevered rate of return/cap rate. doing a quick back of the envelope calculation in excel on first year returns seems to suggest otherwise.
my quick calculations show that there is a spread required from interest rate to cap rate in order to achieve positive first year leverage. It also shows that as amortization tightens the necessary spread increases.
I'm only considering year one one returns with and without leverage, so not taking into account any NOI growth
is my analysis correct here? what am I missing?
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Leverage with interest under your cap rate would always improve your accounting returns, but the amortization will also always result in more cash outflows from your leverage than just the interest unless the terms are I/O.
The form of this relationship is going to change based on the amortization, but yes, you have to pay out additional cash for the principal in year one so even if your interest rate is below your capitalization rate, amortization of the principal will reduce your cash flows, potentially reducing your cash on cash returns below your going in cap rate. From an accounting perspective, equity is still created since you are reducing liabilities though.
Your break even point for positive changes to cash on cash from leverage would then be the point where the annual payments as a percentage of principal are equal to your going in capitalization rate. If the payments as a percentage of principal are lower than your initial cap rate, then you have a positive cash on cash impact, if they are lower then the opposite is true.
Excluding taxes/financial distress/signalling, etc, etc, etc
Read up on mortgage constant in Excel. As stated above, amortization period is key. Lots of "phantom income" with short amortization loans through strong principle reduction.
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