The less down the higher the return
Doing some financial analysis for some real estate properties after a long while. Seems like I have forgotten some of my real estate/investing principles so needed help with a dumb question. Why does putting the least amount down yield the highest return? i.e. in this property, if I put 20% down I make 16% return, if I put 35% down I make 12%, etc. etc. Cash flow is obviously higher (and what matters, for the most part), but this is still bugging me...thoughts appreciated.
IRR requires at least one negative value in a series of cash flows in order to be calculated. For a simple, stable property, your year zero cash flow will be negative (acquisition), you'll get proportionally smaller cash flows each year during your holding period (NOI), and another big cash flow at the end when you sell the property. That initial acquisition cost is not affected by the time value of money, as it is in the present. Using debt to effectively decrease the acquisition cost will generally increase the IRR given that the unlevered IRR is greater than the interest rate. You're basically using debt to spread a portion of the acquisition cost into the future where it's worth proportionally less than the positive cash flows that the property generates. With debt, the net present value of the future levered cash flows will decrease, but given the much smaller initial investment, your IRR will increase. You will make more money on the equity you do invest.
Scenario #1: I put $1 down to get $2 in total ending value after 1 year.
Scenario #2: I put $0.50 down and pay interest of 10% (balloon payment) or $0.05 to get a $2 ending value. Everything is the same between these two scenarios except how I purchased.
Scenario 1 = 100% return
Scenario 2 = (1.45/0.50) - 1 = 190% return
Of course, the higher amount you borrow, the higher your cost of debt. I gave a pretty high cost of debt to illustrate the point even with a fairly high cost of debt. Even more ridiculous was my expected rate of return on the asset. That's just useful in illustrating the point.
Do you get it now?
Leverage...
When talking with clients or guys in my industry making a move in to CRE, the concept of making money on debt is new. I break it down like this...I'm going to borrower money at 3.5% and buy a property making 5%. Not the best example but it's a start and truly the gist of the scenario.
You down with OPP?
You have a higher return because you invested less money. Said another way, you took on more debt (read more risk) so your return should also be higher.
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I would suggest the following educational materials to better understand how to increase your returns in real estate investing:
Almost as good as Rich Dad Poor Dad!
True story... With the internet the game has changed a little. I know several people that learned from Carleton Sheets back in the day. Myself included. No, it's not institutional CRE, but the basics for the average Joe are in there. Back in 1999 I did what he said to do. I ran an add in the San Diego Tribune looking for private money to buy houses. I got 12 phone calls. 60 days later I did in fact own my first house, zero down and with 35k for rehab. Purchase price of $181k, but I financed $215k. It appraised subject to rehab at $240k. Not bad for being 23 with bad credit and only a deposit of $2000 to put down.
His forms and contracts don't pass the sniff test but the principles are sound.
Leverage your equity with more equity and then with EB5 pref equity then leverage that with some debt then add a little more leverage with high flying mezz and then finally build a 1800 foot ultra luxury residential tower in Gilmer, West Virginia. Kick back, relax and call it a day.
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