Despite all the talk of cap rates, which refer to the return produced by an investment purchased in cash, most commercial real estate investments are financed. Otherwise known as leverage, most investors prefer to finance a portion of an investment based on their risk profile. The more leverage used the greater the amount of debt relative to equity and thus the greater the risk. Here are the 4 reasons why investors are willing to incur such risk by using debt financing:
- Perhaps the most obvious reason is that an investor simply may not have enough cash to purchase an investment in its entirety and requires additional funds to acquire the property.
- Even in cases where investors have the funds to purchase an investment in cash, they may choose to use debt financing as part of their larger investment strategy. By using leverage they may acquire more properties thus lowering their risk through diversification. For example, if an investor has $1M in cash they may choose to finance the purchase of 4 properties with a loan-to-value (LTV) ratio of 75%; allowing them to purchase $4M of real estate.
- If the financial leverage is positive the use of debt financing increases an investment’s expected return on equity (I discuss the different types of leverage in my article 3 Types of Financial Leverage). If the cost of funds is lower than the cap rate, the return on equity will exceed the return on an all cash purchase.
- Because the interest on debt is tax deductible financial leverage increases returns by lowering taxable income. The benefits of financial leverage are often magnified when evaluating an investment on an after-tax basis.
For more information or if you have any questions, please contact Ryan Rauner, CCIM at 703-943-7079 and Ryan@RealMarkets.com