The goal of any private investor is to find opportunities that generate the highest returns possible with the least amount of risk. One key metric to pay close attention to when comparing real estate deals and their potential returns is the amount of leverage used in the capital structure. In other words, how much debt is financing the property and generating the returns? More leverage means more risk. Debt financing can enhance returns when projects go according to plan, but it also works in reverse.
The Impact of Leverage on Debt and Returns
Here’s a hypothetical example to show the impact to equity when we finance a project with 85% debt versus 70% debt. The property is acquired for $20 million and held for two years, after which it is sold for $25 million. The cost of interest in the initial investment on both loans is 4% (for the sake of simplicity, we will ignore amortization). The project financed with 70% debt requires $6 million in equity, while the project financed with 85% debt requires only $3 million in equity.
| Acquisition Using 85% Leverage | Acquisition Using 70% Leverage | ||
|---|---|---|---|
| Equity | $3,000,000 | $6,000,000 | |
| Debt | $17,000,000 | $14,000,000 | |
| Projected Cost | $20,000,000 | $20,000,000 |
The property leveraged with 85% debt will generate a profit of $3,640,000 on a $3,000,000 investment, resulting in a total return on equity of roughly 121%. The property leveraged with 70% debt, will generate a profit of $3,880,000 on a $6,000,000 investment, resulting a 65% total return on equity.
| Disposition Using 85% Leverage | Disposition Using 70% Leverage | ||
|---|---|---|---|
| Proceeds | $25,000,000 | $25,000,000 | |
| Accrued Interest | $1,360,000 | $1,120,000 | |
| Debt Balance | $17,000,000 | $14,000,000 | |
| Equity Value | $6,640,000 | $9,880,000 | |
| Total Return on Equity | 121% | 65% | |
However, if the market were to decline by just 5%, investors using 85% financial leverage would lose 79% of their invested capital, while investors who levered at 70% would lose only 35%.
| Disposition Using 85% Leverage | Disposition Using 70% Leverage | ||
|---|---|---|---|
| Proceeds | $19,000,000 | $19,000,000 | |
| Accrued Interest | $1,360,000 | $1,120,000 | |
| Debt Balance | $17,000,000 | $14,000,000 | |
| Equity Value | $640,000 | $3,880,000 | |
| Total Return on Equity | -79% | -35% | |
While money was lost in both examples, the higher-leveraged scenario represents a more substantial loss. Additionally, the property investment capitalized with 70% leverage would better weather an economic downturn, allowing for a higher possibility of restoring profitability after market conditions improve.
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Highly levered projects shouldn’t necessarily be altogether avoided; investors should ensure that they understand the amount of leverage used and are adequately compensated for the level of risk. All other things being equal, investors in the 85% leveraged deal in the example above should be rewarded far more than investors in the 70% leveraged deal. Also, when the property is sold, investors should ensure that they receive a majority of the profits until they have achieved an acceptable return for the risk before splitting the upside with the sponsor.
Unfortunately, there is no set rule or scale that dictates the incremental return one should expect for a higher leveraged investment over another. The great equalizer when comparing investment opportunities is to look at them on an unlevered basis. The unlevered IRR removes the noise created by debt and simply evaluates the asset’s gross investment performance. If one property has a 10% unleveraged internal rate of return while another project has 8%, the former is likely the better opportunity. That said, it is hard to compare deals on one metric alone because of the number of variables that go into creating a financial model.
Watch Marc Turner explain why highly leveraged investments can be riskier despite the potential for higher returns.
The impact of fees is also something to be aware of. It is not uncommon to see sponsors dialing up leverage and also dialing up fees. This stacks the cards in favor of the sponsor, shifts the bulk of the reward to the manager and the majority of risk to the investor. An investor should focus on the return they will receive after fees.
The use of high leverage also provides insight on the fundamental disciplines of the project’s sponsor. At the very least, it shows the sponsor is not afraid to increase the risk for their investor’s capital. That means investors should inquire where else in their underwriting the sponsor may be assuming outsized risk. Further, sponsors who use high leverage may be compensating for a lack of investment capital or simply be naïve that market conditions do not stay constant.
It’s crucial for investors to understand the amount of leverage used in any real estate project, to realize that a higher-leveraged scenario could represent a more substantial loss in the event of a market downturn, and ensure they are adequately compensated for the level of risk taken.
