Measuring the Strength of Real Estate Leverage
In order to measure the leverage we can use the loan constant (k%). The loan constant (k%) measures the cost of borrowing money.
The formula is (k%)=Annual Debt Service (ADS)/Loan Amount. Keep in mind that the ADS typically is static and the Loan Amount typically decreases over time (depending on the loan). If the numerator stays the same and the denominator decreases then (k%) increases. This means that the cost of the debt increases and therefore increase in ROI decreases (unless it is interest only or a negative amortization loan).
This makes sense if you consider that at the end of a 30 year mortgage you are still making a relatively high payment even though the principal is relatively low. For example, a real estate investor secures a mortgage for $150,000. The payment is $1000/month ($12000/year). At the beginning of the loan, the loan constant (k%) is 8% ($12,000/$150,000). However, after 15 years the principal is paid down to $100,000 so the new loan constant (k%) is 12% ($12,000/$100,000). In conclusion loan constant (k%), increases over time in standard positive amortization loans.
Another perspective on the Loan Constant
The loan constant is the financial institution’s return on investment (ROI).
Loan Constant Conclusion
A loan constant measures the strength of leveraging. A lower (k%) value gives a real estate investor stronger leverage. In the next article, we will discuss the difference between positive leverage and negative leverage. This explores the relationship between the loan constant and the investor’s ROI.