When does Debt not make sense?
Obviously if my LIRR is coming in less Han my ULIRR that’s a first tell. Is there any other ways assuming I still have positive CF to cover DS? What if my returns are basically break even between the two?
Try running the lender's/debt returns. If those are higher than yours on the equity side, that should be a good high level sign
Ah, you've hit the nail on the head! Debt doesn't make sense when the Leveraged Internal Rate of Return (LIRR) is less than the Unleveraged Internal Rate of Return (ULIRR). That's a clear sign that the cost of debt is eating into your returns.
But let's not stop there. There are a few other scenarios where debt might not make sense:
If you have enough cash to fund the project outright and you'd rather avoid the risk and potential headaches associated with debt. Sometimes, peace of mind is worth more than potential returns.
If the returns on the project versus the debt are upside down. In other words, the debt would be dilutive to the deal. This is something we're seeing a lot in certain sectors like industrial and multifamily, where cap rate compression has reached extreme levels.
If your returns are basically break-even between the two, it might be worth considering going the equity route. Debt comes with its own set of risks and obligations, and if it's not significantly boosting your returns, why take on the extra burden?
Remember, every situation is unique and there's no one-size-fits-all answer. It's all about weighing the potential benefits against the risks and making the decision that makes the most sense for your specific circumstances. Keep swinging those questions my way!
Sources: https://www.wallstreetoasis.com/forum/real-estate/using-100-equity-for-a-project-does-it-ever-make-sense?customgpt=1, https://www.wallstreetoasis.com/forum/private-equity/thinking-like-an-investor-the-key-financial-metrics?customgpt=1, LBOs - Why repay debt instead of keeping cash flow?, What happens when you finish paying off your house?
Debt side - LTC/LTC, DY, DSCR. Depends on deal but want lower LTC and lower LTV as that's a safer place. DY 7-8% minimum, DSCR 1.25x min for multi, have seen 1.65x for office. Depends on deal but general numbers.
ULIRR > LIRR is an obvious giveaway, but if the two are equal then I don't see why you would take on leverage (unless you're constrained by equity check and/or concentration risk).
Always important to keep in mind that there's a loss of flexibility that comes w/ debt financing. Lenders will often have you reserve money upfront and on a rolling basis to deal with immediate and near-term capex and leasing costs - that trapped money becomes a drag to your returns. They will also have you meet ongoing financial covenants (min DY, DSCR etc.) otherwise they could either sweep your cash or have you inject more equity into the deal. Even simple things like requiring approval for TI and capex spend can be a pain - not to mention the inflexibility of being able to decide when to hold vs. sell.
Not only that, if your equity returns are so skinny to the point where you aren't earning a spread on your leverage, chances are the metrics your lender is seeing when they're underwriting your loan aren't looking so great either (which would translate to loan sizing worse than what you're assuming, leading to lower levered returns)
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