Investment Property

Archimedes, the ancient Greek mathematician, once said that with a long enough lever and a place to stand the fulcrum, he would move the world. Applied in the financial world, leverage refers to the borrowing of capital against the value of an asset, in order to increase the return on cash equity contributed by an investor. Total returns are enhanced provided the cost of borrowed capital (i.e. the interest rate paid on the borrowed funds) is less than the yield earned on the asset itself.

Nowhere is this concept better demonstrated than in the U.S. real estate market, where homeowners utilize unprecedented borrowing capability to purchase property. With 90 to 100% loan-to-value mortgages offered in abundance, residential mortgage borrowers can use their capital to buy bigger and better homes than ever before, or refinance to take cash out to use toward other investments.

However, while such high leverage products have made their way to the residential mortgage landscape, the same cannot be said of the commercial lending industry. Here, loan parameters are set by the predominantly credit conservative, risk averse commercial banks, who require more capital contribution by their lending customers.
That said, rental property investors looking to lever commercial real estate, be it a multi-family building, strip mall, or office building, aren’t likely to find anything higher than a 75% loan-to-value at their bank. However, research reveals alternative niche commercial mortgage lenders willing to offer 90% loans commonly used in the residential mortgage industry. Such mortgages offer tremendous value to commercial property investors looking to enhance the return on their money.

Consider the following comparison of two commercial property investment scenarios, one funded through a typical commercial bank, and the other through a high leverage alternative lender. In this example, we assume the investor has $100,000 of his own capital to invest in the property.

The Power of Leverage
In Scenario A, the investor is limited to purchasing a $400,000 property since the bank will only lend $3 for every $1 the investor contributes (75% LTV).

In Scenario B, the investor can afford to purchase a property 2.5 times more valuable than in Scenario A ($1,000,000) since the lender offers $9 for every $1 the investor contributes.

Now, consider the profits earned in Scenario A vs. Scenario B in a one year time frame, given equivalent assumptions for net rental income as a percentage of value (8%), and property appreciation as a percentage of value (5%). We’ll further assume the interest rate on the loan offered by the bank in Scenario A is 7.00%, and the alternative lender loan rate in scenario B is higher at 8.25%.

In Scenario B, the investor was able to “lever” his $100,000 to buy a larger property, earning an additional $24,750 over the year. Put another way, by using the alternative lender, the return on the equity investment of $100,000 increases from 31% to almost 56%. Additionally, while this analysis shows the return differential over one year, the contrast becomes even greater over a longer period, as the property continues to appreciate.

The above example illustrates how extra leverage can be a powerful tool in enhancing returns in your investment real estate. The challenge for investors then, is to find the right lending program that offers both the best leverage and attractive rates and terms to best meet their goals. Instead of simply defaulting to the loan offered by their local banker, investors should do some diligent research on alternative programs, starting with the Internet. Choosing the right lender can make all the difference in your investment success. I’m sure Archimedes would agree.

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About the Author:
Brett Evenson is Managing Director of Commercial Direct ®, a division of Bayview Financial Small Business Funding L.L.C.