How to Measure Leverage
Comparing the FCRR (baseline) and Loan Constant (k%) (cost of financing) will tell you whether the leverage is increasing overall ROI or decreasing it.
When (k%) is less than FCRR the leverage is in a positive position. The difference in the two is the leverage gap. The leverage gap is the increase in ROI resulting from the leverage. Remember from the last lesson that:
Example: Susan purchases a rental property for $300,000. The annual rents on the property are $37,000. The annual expenses are $12,000, so the NOI is $25,000. The total value ROI is $25k/$300k = 8.3%
The note on the property is for $210,000. The interest is 4.5% and it is on a 30 year amortization. Payments are $1064 per month ($12,768 per year). The Loan Constant (k%) is $12,768/$210,000 = 6.08%.
The FCRR (8.3%) is greater than (k%) (6.08%), so this property is in a positive leverage position. This means that the cost of the loan is less than the amount of profit the investor is earning. The leverage gap is 2.22% (8.3%-6.08%), or ROI is increased by 2.22% with the leverage.
When (k%) is more than FCRR, the leverage is in a negative position.
Example: Susan keeps the property and decides to continue to pay the principal down for the next 20 years. The principal owed is now $102,668, so (k%) = $12,768/$102,668 = 12.44%. FCRR is the same 8.3%. Susan’s property is now in a negative leverage position. The leverage gap is -4.14%, or ROI is reduced by 4.14% from the leveraging.
Example Showing Leverage Over Time
This case study will show how leverage changes over time. Leverage position shifts over time as principal is reduced. In the following example you will see the effects of time on leverage position.
- Purchase Price: $500,000
- Loan Amount: $400,000
- Interest Rate: 5.00%
- Term: 30 yrs
- NOI: $35,000
- NOI Annual Increase: 1%
The graph below shows the FCRR in blue and the Loan Constant (k%) in red over a 15 year period. On the left side of the graph, positive leverage is displayed, and on the right side, negative leverage is displayed. When FCRR (blue line) is higher than (k%) (red line) the property is in a positive leverage position. The gap between the two is the Leverage Gap, or the ROI on the leverage.
When (k%) (red line) is above FCRR (blue line) the property is in a negative leverage position. The gap between the two is the leverage gap however, when (k%) (red line) is higher than FCRR (blue line) the leverage gap is negative. This means that the leverage is reducing the ROI on the investment.
As you can see, year nine is the break even point. Break even is when (k%) = FCRR.
In the first year the FCRR is 7.00%* and (k%) is 6.44%**. The gap is .56%***. In other words leverage increases ROI by .56% or $2800 in the first year!
In the graph above, the gap between the red and blue line left of the “break even” point.
* FCRR $35,000 / $500,000 = 7.00%
**(k%) $25,767/$400,000 = 6.44%
***Leverage Gap 7.00% – 6.44% = .56%
Positive Leverage = Higher Returns
Investor buys with cash Investment: $500,000 Return: $35,000 ROI: 7%
Investor uses leverage Investment: $100,000 First Year Return: $9,232 ($35,000 – $25,767) ROI: 9.23%
Annual Debt Service (ADS) – Total annual mortgage payments including principal and interest.
Debt Coverage Ratio (DCR) – Ratio of after expense income (NOI) to ADS. NOI/ADS = DCR
Equity – The value of an ownership position. Sally puts $10,000 down on a $100,000 house. The value of the house goes up $10,000. Now Sally’s Equity position is $20,000.
Loan to Value (LTV) – Is a ratio of the amount of the loan compared to the value of the property. Loan Amount / Property Value = LTV
Net Operating Income (NOI) – All income minus all expenses (do not include ADS).
Return on Investment (ROI) – One year return on investment. NOI/initial investment = ROI
Free and Clear Rate of Return (FCRR) – ROI on a real estate investment if the property were paid for with cash. Used as baseline when measuring leverage position.