Impact of Leverage on Cash-on-Cash Returns

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Impact of Leverage on Cash-on-Cash Returns

J ScottPro Member
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Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes

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!

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Nancy L.
Philadelphia, PA · Member since 2014 · 178 posts · 64 votes
11y

@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.

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  • Ciro LoCascioPro Member
    Investor · Queens, NY · Member since 2013 · 135 posts · 39 votes
    11y

    Thanks for the info. Very interesting!

    0Reply
  • Seth Mosley
    Rental Property Investor · Franklin, TN · Member since 2014 · 145 posts · 44 votes
    11y
    Super helpful! I am almost there to maxing out my 10 conventional mortgages and beginning to look to portfolio / commercial loans as my next step... Gotta keep adding properties to the portfolio somehow!
    0Reply
  • Adam Moehn
    Investor · Cedar Rapids, IA · Member since 2009 · 143 posts · 29 votes
    11y

    Interesting, it's more exponential than I'd have expected.

    0Reply
  • John Matthews
    Investor · San Diego, CA · Member since 2014 · 254 posts · 56 votes
    11y

    This has answered a question I've had for the past two weeks that I didn't know I had - Thanks!

    0Reply
  • Andrey Y.
    Specialist · Honolulu, HI · Member since 2014 · 1k+ posts · 1k+ votes
    11y
    Originally posted by @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!

     Really useful bread and butter info for us newbies. If I am able to get a conventional loan and portfolio loan at the same rate (say 4.5%), J which would you choose for a medium-long term B&H strategy?

    0Reply
  • Michael Noto
    Real Estate Agent · Southington, CT · Member since 2008 · 5k+ posts · 3k+ votes
    11y

    This is interesting.  Thank you for sharing.

    0Reply
  • Nancy L.
    Philadelphia, PA · Member since 2014 · 178 posts · 64 votes
    11y

    @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.

    1Reply
  • J ScottPro Member
    Moderator
    OP
    Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
    11y
    Originally posted by @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.

     Of course!  Let me know if I can provide anything else...

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  • Nancy L.
    Philadelphia, PA · Member since 2014 · 178 posts · 64 votes
    11y

    @J Scott Thanks so much! I'm actually pretty excited about it... While I can't get into too many specifics, I can explain what the axes mean and use this to demonstrate a few ideas we're discussing.

    0Reply
  • Dawn AnastasiPro Member
    Rental Property Investor · Milwaukee, WI · Member since 2013 · 6k+ posts · 4k+ votes
    11y
    Originally posted by @Nancy Larcom:

    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 would really like to know how to use the calculus I learned in every day life.  I've been waiting 20 years for some way to use it and never have. Anyone?  Anyone?  :)

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  • J ScottPro Member
    Moderator
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    Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
    11y
    Originally posted by @Dawn Anastasi:
    Originally posted by @Nancy Larcom:

    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 would really like to know how to use the calculus I learned in every day life.  I've been waiting 20 years for some way to use it and never have. Anyone?  Anyone?  :)

    I actually used it yesterday.  Was driving with someone on a toll road, and he was speeding.  I was explaining to him that, if the cops wanted to catch him speeding, all they'd need to do was check the amount of time it took him to get from one toll booth to another, and then divide by the distance.  This would give his average speed for the duration of the trip.

    His defense was that knowing the "average" speed wouldn't prove that he was speeding at any one specific point during the trip.  But, as I explained, one of the most important theorems from Calculus is "The Mean Value Theorem," which -- as applied to this situation -- says that if his average speed of the trip is X, then there MUST be at least one point in the trip where his speed was X.  

    In other words, based on Calculus, if his average speed is above the speed limit, there was at least one point where he was speeding.

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  • Dawn AnastasiPro Member
    Rental Property Investor · Milwaukee, WI · Member since 2013 · 6k+ posts · 4k+ votes
    11y
    Originally posted by @J Scott:
    Originally posted by @Dawn Anastasi:
    Originally posted by @Nancy Larcom:

    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 would really like to know how to use the calculus I learned in every day life.  I've been waiting 20 years for some way to use it and never have. Anyone?  Anyone?  :)

    I actually used it yesterday.  Was driving with someone on a toll road, and he was speeding.  I was explaining to him that, if the cops wanted to catch him speeding, all they'd need to do was check the amount of time it took him to get from one toll booth to another, and then divide by the distance.  This would give his average speed for the duration of the trip.

    His defense was that knowing the "average" speed wouldn't prove that he was speeding at any one specific point during the trip.  But, as I explained, one of the most important theorems from Calculus is "The Mean Value Theorem," which -- as applied to this situation -- says that if his average speed of the trip is X, then there MUST be at least one point in the trip where his speed was X.  

    In other words, based on Calculus, if his average speed is above the speed limit, there was at least one point where he was speeding.

     J Scott is a nerd!  Awesome sauce!

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  • Jason Mak
    Rental Property Investor · San Marino, CA · Member since 2011 · 398 posts · 144 votes
    11y

    @J Scott  Thanks for the great thread!  Embarrassed to say but I had to google "is X-axis the horizontal or vertical line".  Been too long out of school for me...haha

    1Reply
  • Nathan J.
    Saugerties, NY · Member since 2014 · 98 posts · 32 votes
    11y

    That's very interesing @J Scott . Thanks for sharing.  Given the above theory, how would the community approach the following situation:

    Assume conventional financing on a 30 yr fixed loan. Strategy is buy and hold investment on a SFH. Lets assume purchase price is around 80-120k.

    Would you:
    a) put down 25% and pay 4.5%
    b) put down 20% and pay 4. 875%  
    Note: my lender tells me its a .375% premium to use a lower downpayment.

    Appreciate your insight....

    0Reply
  • Nathan J.
    Saugerties, NY · Member since 2014 · 98 posts · 32 votes
    11y

    Note that actual mortgage rates are perhaps 50bp lower than what i quoted above, but i am note sure it affects the principle (or does it?)

    0Reply
  • J ScottPro Member
    Moderator
    OP
    Investor · Sarasota, FL · Member since 2008 · 17k+ posts · 17k+ votes
    11y
    Originally posted by @Nathan J.:

    That's very interesing @J Scott . Thanks for sharing.  Given the above theory, how would the community approach the following situation:

    Assume conventional financing on a 30 yr fixed loan. Strategy is buy and hold investment on a SFH. Lets assume purchase price is around 80-120k.

    Would you:
    a) put down 25% and pay 4.5%
    b) put down 20% and pay 4. 875%  
    Note: my lender tells me its a .375% premium to use a lower downpayment.

    Appreciate your insight....

    From a pure COC standpoint, the lower downpayment and slightly higher rate is a better choice given a $100K property, $1500/month in rent and 50% expenses. COC is closer to 20% in the lower downpayment scenario vs 18% in the higher downpayment scenario.

    But, what would you do with the $5K you'd save?  Could you invest that at a reasonable rate or would it sit in a savings account earning 2% for the next 5 years?

    Personally, I'd go with the lower downpayment and invest the $5K in another deal...

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  • Mike H.
    Rental Property Investor · Manteno, IL · Member since 2009 · 2k+ posts · 2k+ votes
    11y

    One thing about the portfolio loan to keep in mind though is the risk factor. 

    So, I think someone asked the question as to whether they should go with the conventional or portfolio loan because they both have the same rate.

    Everything being equal, I'd use up all your conventional loans first if you can. The only exception might be if you have a property thats a bit of an outlier on the loan amount than your typical deal. I might not use up a conventional loan spot on that one and instead go with a portfolio loan.

    Lets say a typical deal loan for your properties is 100k but you pick something up thats a little different from your typical model and the loan would be 50k. I'd put that into the portfolio if I could before burning one of my conventional spots.

    The hit later on, if the rate changes, would be much smaller on a 50k loan than on a 100k loan. So the more 100k loans I could lock in at 30 years, the better.

    At some point, that portfolio loan may end up jumping from 4.5 to 5.5 and maybe even to 6.5%....... 

    I'm willing to take that risk because my assumption is that when it jumps, I'll owe less money on the loan so my overall profit will remain about the same. But if rates ever did get really crazy again - say 7.5% or 8 - , then those portfolio loans might be a little light on the profits..... :-)

    But I liked the exercise and seeing the numbers.

    1Reply
  • Steve L.
    Investor · Rancho Cucamonga, CA · Member since 2008 · 1k+ posts · 684 votes
    11y

    Now let's assume you can buy the rental with a 25% discount all in and refinance at 65-70% LTV of market value 3-6 months later. pretty compelling difference to your roi.

    Wish I bought more... much harder now.

    1Reply
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