Impact of Leverage on Cash-on-Cash Returns

[J Scott]

In the spirit of truly understanding some important concepts behind investing decisions many of us are making, I wouldn't to start this thread...

Basically, I was surprised at the information I'm about to provide (I did this analysis in another thread a couple days ago and got some unexpected results), and figured a couple of you may be surprised as well.  At least for me, it will impact some decisions I make down the road...

Assume a rental property that generates 2% of its cost in monthly rent and that operates at a 50% expense ratio (actually, expenses + rent loss + capex).  Further, assume the property is leveraged somewhere between 0% (all-cash, no leverage) and 100% (fully leveraged at all-in acquisition cost).

The following graph plots two curves -- one representing a typical conventional loan amortization/rate and the other representing a typical portfolio loan amortization/rate -- with leverage amount indicated on the X-axis and it's resulting cash-on-cash return indicated on the Y-axis:

What I see in this graph:

• Below 60% leverage, CoC is basically flat, without much opportunity for leverage to impact CoC, regardless of type of loan
• Between 60-80% leverage, amortization/rate of the loan will determine whether you can start to increase your CoC or not
• Above 80%, any positive leverage will greatly increase your CoC, but the amortization/rate will play a HUGE role in the extent of the increase

The key takeaway for me is that, for lower amounts of leverage, conventional versus portfolio loans make no difference -- and, in fact, leverage doesn't make much of a difference at all. For medium amounts of leverage (60-80%), there is a big difference in CoC based on type of loan chosen. And for larger amounts of leverage, both loan choices are good, but conventional terms/rates are very beneficial.

There are some obvious implications here (for me, at least) in terms of:

• Whether I would even want to leverage at lower percentages, given the paperwork, DTI hit and loan costs
• What types of loans I would pursue based on the amount of leverage available
• The value of using the small amount of conventional loans available to their best advantage

Anyway, thought the results were interesting, and thought I would post them...enjoy!

[Nancy L.]

@J Scott This is great! I teach math part-time at a local high school, and after a recent discussion with my students about if/how the math (and specifically graphing concepts) we teach is useful, I'd really like to use your graph in a lesson if that would be ok? I won't be able to get into the specifics too much with them right now, but am planning a mini-unit on real estate investing when we get to a relevant point in the curriculum (I'm going to use exponential functions/compound interest formula as a jumping off point). I think they'd be impressed to see a graph from a "Real Life Investor," instead of the cheesy textbook examples they're used to.