Working through a RE mental math problem and trying to understand the logic behind it. I know that if your cap rate is lower than your interest rate you have negative leverage. BUT what does it mean if your cap rate is equal to your interest rate? Does it mean you are capital structure neutral? Would your levered CoC then be equal to your unlevered CoC? Would appreciate any insight. Thanks!
| +68 | Hiring Analyst/Associate - Advice | 31 | 7h | |
| +40 | Current CRE Phase | 19 | 2d | |
| +36 | Laid Off - Multifamily Acquisitions Help | 8 | 1d | |
| +26 | Best Brokerages in South Florida | 18 | 21h | |
| +26 | Capital Formation | 9 | 3d | |
| +25 | PART 2: Increasing RE Industry's Cash Compensation, Collectively | 1 | 4d | |
| +24 | URGENT - a list of Halal/Islamic real estate funds and investment companies for potential applications | 9 | 7h | |
| How many days a week are you expected to be in the office? | 23 | 3h | ||
| +23 | NYU MSRE Program | 7 | 2d | |
| +22 | UK Development | 4 | 12h |
Career Resources
Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling.
It's not necessarily true that if your cap rate is lower than your interest rate, you have negative leverage. With that logic almost every deal would be underwater right now. Take a 1m purchase price, 50k NOI, 60% LTV, 7.5% interest rate - that would give you a 5% cap rate. At 60% LTV, your loan balance would be 600,000 * that 7.5% interest rate you have annual debt service of 45,000. Excluding any other below-the-line items, you would still have a positive cash flow of $5,000 per year.
If your LTV/LTC is 100%, then a higher/lower cap rate to interest rate would cause negative/positive leverage. As for CoC in that situation... when the cap rate equals the interest rate, it suggests a balanced capital structure, and your levered/unlevered CoC would be around the same.
It should be noted if your loan constant is higher than your cap rate you generally have negative leverage and vis versa
Please see the comments below for a different and helpful perspective on the topic
This is super helpful.
I found this informative article based on the concepts you mentioned here:
https://blog.stacksource.com/the-loan-constant-f73954464645
The concept of negative leverage isn't if you can service your debt.
If your cost of debt is higher than your income, by any margin, then your CoC will be lower as the debt is not accretive.
Yeah, not following the original example.
In this example, your unlevered yield is $50,000 / $1,000,000 = 5%. Your debt service (which assumes interest only) is $600,000 * 7.5% = $45,000. So your net levered cash flow is $5,000. Your equity basis is $1,000,000 - $600,000 = $400,000. Your cash on cash yield is $5,000 / $400,000 = 1.25%. So by definition your debt is dilutive to your return keeping all else equal.
Your cap rate - cost of debt is often referred to as your debt to equity spread. Taking on negative debt to equity spread is short handed as negative leverage.
To your original question, if your cap rate is equal to your interest rate, then yes - it's neutral leverage. Use the same example but with a 5.0% interest rate. Your debt service is $30,000, your net levered cash flow is $20,000 on $400,000 is a 5.0% yield. Which is equal to your unlevered yield (or cap rate) of 5.0%.
What exactly are you trying to better understand or get at beyond this?
In any case, hope this helps.
Exactly. Negative Leverage is really about if your cash on cash return is lower with debt than without it, not just if you can service it. So in the above example, yes you can cover the interest-only loan with 5k to spare but your cash on cash return would be 1.25% as Esque points out, which is lower than your unlevered yield of 5%, therefore debt is not accretive on this deal.
One thing a lot of people miss on this math is that its not actually the interest rate itself that matters, its the associated debt constant i.e. total debt service as a % of loan amount.
Explain?
If I buy something at a cap rate of 5%, with 3% with 60% LTV, that is a CoC of 8%.
If the cost of debt is instead 8%, the CoC is 0.5%.
At 30% LTV the debt is still dilutive
At a cost of 3%, the CoC is 5.85
And at a cost of 8%, the CoC is 3.71
Irrespective of the quantum, it's still dilutive. Ie the interest rate is the driver...
Who said anything about LTV? Debt constant is your debt service (principal + interest) expressed as a percentage. From a perspective of whether something is accretive to CoC that is what matters unless your debt is I/O. Saying it is accretive to yields based on interest rate alone ignores the principal portion.
In your example above (5% cap rate, 3% interest rate, 60% LTV) assuming 30 year amortization, your CoC would be 4.85% i.e. dilutive to annual yields.
Now that being said, if we're talking accretive to IRR, then if your UIRR is greater than interest rate, that is accretive.
Libero tempore et esse sapiente veritatis similique. Ducimus voluptatem quas nemo explicabo vero. Qui nulla iste consequuntur est vero. Nihil nisi quasi eos doloribus sit. Sit fugiat cupiditate cumque repellat corporis sunt sunt. Non et ducimus quidem mollitia et. Provident nesciunt est nobis inventore harum aut.
Impedit sed qui nihil animi id. Et similique cumque in eos nisi vero sit. Cupiditate aut praesentium maiores debitis.
Et totam aut asperiores sunt non. Illo dolorum sit dolores suscipit qui veniam maiores.
Nisi expedita et expedita occaecati sit. Excepturi vel illo iste asperiores.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...