The Beauty of Leverage in Multifamily InvestingPaul Winterowd
Using Leverage to Increase Your ROI
When deciding how to invest your hard-earned money, multifamily investments continue to be a source of above-average returns. Data from a recent study forecasts a healthy economy and even more lifetime renters as interest rates rise and the housing market shifts.
Some refer to profits from real estate investments as “mailbox money”—checks that show up in your mailbox from your savvy real estate investments. But how can you increase these returns? The answer is simple—so simple you may overlook it.
One word: Leverage.
We use leverage in the general sense in our everyday interactions, relationships, and even practically in day-to-day tasks. Think of the root word—lever. A lever is a simple tool used to move more with minimal effort. The same principle is applicable in real estate investing: leverage allows you to move more money with less effort.
For example, it is much quicker and easier to save $250,000 to buy a $1 million piece of real estate and get a loan for the other 75% of the required funds than saving $1 million to buy the property without a loan.
This is Real Estate Investing 101. In this blog we’ll extrapolate this simple example to learn what leverage can really do for you and your multifamily investments, and we’ll demonstrate how you can increase your ROI by leveraging leverage.
What can leverage do for you?
If you’re asking yourself, “What can leverage really do for me?” the answer is leverage increases the return on your investment. Let’s look at two investment scenarios, one using leverage and the other without leverage, to better understand the financial rewards of using leverage in your multifamily investments.
Here are our assumption in each scenario: There’s a multifamily property with a purchase price of $5 million. The net operating income (NOI) is $300,000 and the maximum loan-to-value (LTV) is 75%. The minimum debt coverage ratio (DSCR) for the deal is 1.25. The interest rate is 5.0% and the hold period is set at 5 years. Finally, the net sales proceeds are $6 million.
(For more information on DSCR, check out our explanatory post here!)
For an investor without debt who is putting up the sale amount themselves—a.k.a. not using leverage—the internal rate of return (IRR) would be 9.32%. If that same investor used leverage, or a loan, to help finance the investment, the IRR would be 16.25%.
Let’s look at it another way. If you invest $5 million in apartment buildings without using leverage to finance the investment, your $5 million grows to $7,806,711 at 9.32% growth. But with leverage (a loan), your $5 million multifamily investment grows to $10,615,362 at a 16.25% rate.
By using leverage to help finance your multifamily investments, you are increasing your average rate of return. This also increases your risk. As you borrow money and take on the obligation to repay that amount plus interest, the risk element of your investments increases. But as you know, whenever there is a greater risk, there is a greater reward.
Leverage is the gateway to greater net worth
Investing in multifamily properties often creates a snowball effect for our clients. They use financing options and leverage to begin their real estate portfolios, but as investors acquire more properties and their net worth increases, they are then able to qualify for and invest in more multifamily properties. This is how wealth is acquired.
Leverage is the gateway that allows you to control more multifamily real estate. Because multifamily values are tied to cap rates and NOI, slight increases in NOI create significant increases in value. Thus, by controlling more real estate using leverage, and managing those assets wisely to increase NOI, you can greatly increase your net worth.
Let’s look at one other example of how using leverage can affect a property’s overall returns. Our assumptions for this multifamily investment scenario are that the loan type is a cash-out refinance. The appraised value is $10 million, the outstanding loan balance is $6 million, and the Gross Rental Income (GRI)is $1.2 million. The annual rent increase is 2%, the operating expenses are 40% of the GRI, and the vacancy rate is at 5%. The loan hold period is 10 years and the cap rate at exit is 6%, while the disposition costs are 4% of the sales price.
In the chart below, we illustrate the limiting factors and calculate an investor’s rate of return and cash out in two different loan scenarios.
|Fannie Mae/Freddie Mac Loan||HUD 223(f) Loan|
|Loan Closing Costs||1.5% of loan amount||3% of loan amount|
|Cash Out at Closing||$1.5 million||$2 million|
Which loan is more appealing? With the HUD 223(f) loan you pay 1.5% more in closing costs, but you get an additional $500,000 out of closing that you can reinvest in other multifamily properties or—who knows!—take the vacation of your dreams to Bora Bora.
The HUD loan provides the highest leverage in multifamily loans if you want to maximize the return on your investment. In this situation, it’s a smart choice to go with the HUD loan. But evaluating which loan option offers the most leverage can be tricky—that’s why we recommend working with a professional capital firm like Bonneville Multifamily Capital to help you broker the best deals and maximize the leverage for your multifamily investments.
The power of leverage provides more liquid capital for investing and reinvesting and higher returns for investors. Many beginner investors are cautious to use loans and leverage to help make their deals happen, but risk and reward are two sides of the same coin. Leverage is the way to higher returns and wealth creation for multifamily investors.