Debt and Equity

The way an investment or entity is funded is referred to as its capital structure, or “cap stack” for short.

Broadly speaking, the capital stack consists of two components: debt and equity. Debt is effectively a loan to the investing party (you), which most commonly comes from a bank or specialty lender, but also includes other types of financing, like a HELOC or a credit card. Equity represents how much you actually owns in the investment. As such, the equity investors retain “control” of the investment and make major decisions, so long as they remain in compliance with the loan documents.

Investors use debt (aka ‘financing’ or ‘credit’) because it can lead to higher investment returns on their equity and helps stretch their investable dollars further. The amount of debt incorporated into a capital stack is known as leverage.

Debt investors (aka lenders) benefit from repayment priority and typically have the ability to foreclose on an asset if the borrower defaults, which makes it less risky than an equity investment. For that reason, equity investors demand higher returns than debt investors.

All Equity vs. Levered

• It can be used by investors to enhance returns by intentionally introducing a quantifiable amount of risk.

• It allows investors to take on more/larger deals than they would otherwise be able to with their readily available cash. 

However, if not used responsibly, or if luck is not in your favor and the market suddenly turns against you, leverage can quickly erode returns and even worse, result in a complete loss of investment.

Backflip’s team of professionals can help real estate investors project and understand both unlevered and levered returns, so you are well informed to choose the optimal capital structure for your proposed business plan.

Leverage and Risk

Leverage, when used as a noun, is the ratio of the amount of debt (loan capital) to the value of the equity (cash or balance sheet equivalent). If an investment property has $100K of debt and has a total value of $150K (implying $50K of equity value), then the leverage ratio is $100K/$50K or 2:1. That can also be described as 66.7% leverage ($50K/$150K). 

Unlevered yield refers to the profitability of an investment without considering debt financing. An investment is said to have “positive leverage” when the interest rate on the debt is lower than the unlevered yield on an investment. Positive leverage is good: it means your investment is bringing you income, while hopefully also increasing in value.

Negative leverage occurs when the interest rate is higher than the unlevered yield, and the leverage is dilutive to returns. What’s happening in high-interest situations like this is that the debt investors (the lenders, the banks) are being compensated more than the equity investors, despite taking less risk. 

Sophisticated investors seek to maximize their risk-adjusted returns. They want to generate the highest possible returns relative to a quantified level of risk. Utilizing leverage is an effective means to increase returns while thoughtfully dialing up the risk. (If the game was ONLY about getting the highest returns without regard for risk, there are plenty of casinos in Las Vegas who would happily take the other side of that trade.)

Leverage Impact on Cash Flow Yields

Let’s look at the impact of leverage in action. We’ll use the $240K property above, and assume it generates $12K in annual net operating income, resulting in a 5% unlevered yield ($12K ÷ $240K). 

The table below illustrates how the levered yield changes based on the interest rates that are less than, equal to, and greater than the unlevered yield. You can see how the leverage magnifies the returns in either direction. 

To further emphasize the point, the figures below were adjusted to assume 90% leverage (up from 75%) and the resulting Levered Yields were magnified even further; up from 8% to 14% and down from 2% to -4%.

Magnified Gains and Losses

In short, capital structure can be as important as the investment strategy or market in determining the outcome of an investment. Leverage used well can be a great tactic to achieving your target investment returns. 

Of course, leverage both magnifies both gains and losses. If the investment performs better than the cost of the financing, returns to equity will be juiced. But leverage also exacerbates losses—especially if the value of the asset were to drop below the loan amount and you did not have enough money on hand to rebalance the loan.

Diversification

Another benefit of leverage is that an investor can diversify their cash across an increased number of properties. By definition, diversification reduces risk and adds stability to an investment portfolio.

Expanding on the levered scenario above, imagine rather than acquiring a single $240K property, you use your $60K of investable cash to purchase two rental properties for $120K each, with 75% leverage on both. Now, if one of the tenants leaves, your investments are 50% leased, as opposed to 0% if you only owned the single property.

How to Calculate Your Investment

You can use a quick calculation to determine the size of investment you can afford if you know how much cash you have to invest and what amount of leverage you want to use.

The formula is: 

Investment Size = Cash Equity / (1 – Leverage %)

Using the example above: 

Investment Size = $60K / (1 – 75%)

Investment Size = $60K / 25%

Investment Size = $240K

Your Optimal Capital Structure

The very safest thing is to simply avoid leverage in the capital structure. It is extremely difficult to realize a 100% loss on an all-equity real estate investment, so long as a reasonable level of due diligence is completed prior to the acquisition. Even if the property burns to the ground and you don’t have insurance to pay for reconstruction, in theory there would still be value in the land. The possibility of a complete loss enters the picture along with leverage.

That said, exclusively using equity requires investors to have a large amount of investable cash, and is overly-conservative for investors who are looking to optimize risk-adjusted returns. Nearly all real estate investors in the world incorporate leverage into their business plans.

Determining the optimal capital structure for an investment is both an art and a science. There are many variables to consider, some of which are outlined below. 

1. The cost of capital should be lower than the anticipated investment return. Otherwise, the investment will not be profitable.
2. The capital structure should match the business plan for the investment. For instance, if the property is leased upon acquisition and the business plan is to hold it as a rental for 10 years, using a 12-month loan is not advisable. 
3. Additionally, the capital structure and terms should be flexible enough to accommodate reasonable deviations to the business plan, especially regarding things that are somewhat outside of one’s control (for instance, if a rehab project lasts one month longer than planned because the flooring material shipment was delayed).
4. Investors (debt and equity) should be good partners, with their interests aligned in helping create value for the investment. Even when all of the points above are true, if a prospective investor has a history of being a bad partner then it is usually wise to consider alternatives if possible.

It is important to remember that the goal shouldn’t be to blindly maximize leverage in all circumstances, which can lead to reckless risk-taking. Increasing leverage from 85% to 95% introduces a material amount of risk that may not be worth the additional investment returns.

There are definitely situations where using leverage is not advisable: a good example is land investments that are not producing any cash flow and don’t have a near-term exit strategy. At Backflip, we’ll help you figure out the optimal capital structure for your specific investment plan, so you rest easy knowing you’re getting the best risk-adjusted return on your project.