One of the most common mistakes made by investors when evaluating a real estate equity opportunity is under-estimating the risk of debt. Investors tend to focus on the upside of deals, looking at the advertised expected internal rate of return (IRR) or equity multiple, without quantifying and adjusting their return requirement adequately for the risks taken.
But the reality is that debt has a large impact on the level of risk an investor faces and, for this reason, I believe every investor should understand how to use weighted average cost of capital (WACC) to quantify debt risk. WACC is defined as the weighted average of the all sources used to finance an investment. Put differently, WACC is also the investment’s cost of capital — both debt and equity — or the required return on total capital to meet the goals of the investment.
An investor should always be sure they are aware of how the deal will be funded — specifically, how much senior debt, junior debt and preferred equity they will use. Debt is almost always cheaper than equity in this equation, because it is repaid first and has a first lien on the real estate collateral until repaid, so it’s considered the least risky investment. The equity input into the WACC formula is an estimate based on the management team’s assumptions on the business plan, which a prospective investor should make sure to receive and evaluate.
The WACC Formula:
(% Debt Financing * Cost of Debt) + (% of Equity Financing * Cost of Equity) = WACC
Let’s use this formula to analyze an Origin deal that was capitalized with 60% debt at 5% debt cost and 40% equity at 20% equity cost. We’ll then compare what happens when we take the same investment with the same asset-level risk and business plan, but use more debt and less equity.
(60% * 5%) + (40% * 20%) = WACC
3% + 8% = WACC
11% = WACC
Therefore, our investment’s total cost of capital — across debt and equity — is 11%.
Now, if we increase the amount of debt but keep the same 11% WACC, let’s determine what the new cost of equity will be. The cost of debt will also increase in this scenario because lenders always charge more interest when they lend higher levels of capital, since they are taking on more risk. Note that Origin avoids using more than 75% debt on any deal, but many other managers do.
Keeping the WACC at 11% with the higher debt level of 80% at a 6% debt cost, we’re now solving for x, the new cost of equity.
(80% * 6%) + (20% * x) = 11%
4.8% + 20%x = 11%
20%x = 11% – 4.8%
20%x = 6.2%
x = 6.2% / 20%
Our new cost of Equity is 31%.
Simply by moving the amount of debt from 60% to 80%, the required cost on equity increased from 20% to 31%. As you can see, the use of more debt increases the risk of a private real estate opportunity and increases the required return to compensate equity investors.
Investors should be sure to use the WACC formula to quantify debt risk with investments they are considering and be wary of deals that have loan-to-value ratios that exceed 75%. Do not just focus on the returns that are being presented, as often times these returns are inflated with assumptions that are difficult to meet. Reputable managers should be transparent and upfront with the amount of debt used in their deals, but remember, the operator wants to raise capital for their project in the most affordable way possible. It is up to the equity investor to demand a fair return for the risks taken.