The way an investment or entity is owned and funded is referred to as its capital structure, or “cap stack” for short. One might ask, “how is this investment capitalized?”.
Broadly speaking, the capital stack consists of two components – debt and equity. Debt is effectively a loan to the investment entity, which most commonly comes from a bank or specialty-lender, but also includes other types of financing like a HELOC or even a credit card. Equity represents ownership 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 (sometimes called ‘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 commonly referred to as leverage.
Debt investors benefit from a repayment priority and typically have the ability to foreclose on the collateral if the borrower defaults, therefore it is not as risky an investment as the investment of the equity investors. For that reason, equity investors demand higher returns than debt investors.
All Equity vs. Levered
Let’s say you have $60K of cash to invest in a property.
One option would be to acquire a $60K property. However there are a handful of reasons why that might not be the best option. In that scenario the capital stack would be 100% equity.
Another option is to finance a portion of the investment with debt. With moderate leverage incorporated into the capital stack, say 75%, you can afford a $240K property. Here the capital stack is 25% equity and 75% debt. You would still own 100% of the asset while only investing 25% of the required cash.
Like anything, it gets more complicated from here – there are many types of debt and many types of equity that are useful to understand after you grasp the basics. We’ll save the complexity for later (or keep scrolling to dive a bit deeper).
The correct takeaway here is that leverage can be a powerful tool.
- It can be used by investors to enhance returns by intentionally introducing a quantifiable amount of risk.
- It allows investors to take on more or larger deals than they would otherwise be able to if limited to 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 they are informed to choose the optimal capital structure for their proposed business plan.
Tell me more…
- What is Leverage?
- Importance of Capital Structure
- How to Calculate Your Investment
- What Is Your Optimal Capital Structure?
What is Leverage?
Leverage, when used as a noun, refers to a ratio of the amount of debt (loan capital) to the value of the equity (cash or balance sheet equivalent). For example, if an investment, let’s say a 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. You could also say that there is 66.7% leverage ($50K / $150K).
An investment is said to have positive leverage when the interest rate on the debt is lower than the unlevered yield on an investment. This relationship causes the levered yield to be higher.
Sophisticated investors are most concerned with maximizing their risk-adjusted returns. They want to generate the highest possible returns relative to a quantified level of risk. Utilizing leverage is an extremely effective means to increase returns while intentionally dialing up the risk. If the name of 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.
Negative leverage occurs when the interest rate is higher than the unlevered yield, and as a result the levered yield is lower than the unlevered yield – in other words – the leverage is dilutive to returns. What’s happening in situations like this is that the debt investors are being compensated more than the equity investors, despite taking less risk.
Leverage impact on cash flow yields
Let’s look at an example to show 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%.
Importance of Capital Structure
Simply put the capital structure can be as important as the investment strategy or market in determining the outcome of an investment. Leverage, when used prudently, can be a great way to achieve your target investment returns.
Incorporating leverage both magnifies gains and losses. If the investment performs better than the cost of the financing, returns to equity will be juiced. However, it is important to remember that leverage also exacerbates losses, and can lead to a total loss if the value of the asset drops below the loan amount and you do not have enough liquidity to rebalance the loan.
Appreciation accruing to equity
Suppose the market has gone up and the market value of the $240K property in the example above increases by 5% ($12K) so it is now worth $252K.
The amount of debt on the property remains unchanged at $180K, so all of the appreciation accrues to the benefit of the equity investors. In this scenario the equity is now worth $72K, a 20% increase over the $60K of the invested cash equity.
It works the other way too – a 5% reduction in asset value to $228K would result in a 20% decrease to the value of the equity position.
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, you can now buy 2 houses.
For instance, rather than acquiring a single $240K property, you could use your $60K of investable cash to purchase two rental properties for $120K each, assuming 75% leverage on both. This way, 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 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 residual 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 arguably too 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.
- The cost of capital should be lower than the anticipated investment return. Otherwise, the investment will not be profitable.
- 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.
- 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).
- 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. By partnering with 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.
Jake, I love the simplicity and value of this information. Very well done.
Thanks, Curtis! We really appreciate the feedback!