Investing for Yield
Many sophisticated investors use leverage when buying income property. Leverage is using a small amount of money to control a large asset. For example, a 10% down payment provides 9 to 1 leverage on the purchase. The remaining 90% is financed as debt. The lender provides $9 for every $1 of the investor. The Leverage to Debt (LTD) is 90%÷10% = 9.
I define an asset as something that produces spendable cash into your pocket. A liability is something that consumes cash from your pocket. For example, a $1,000,000 apartment building generates $100,000 per year in Net Operating Income (NOI). The NOI is calculated as Gross Operating Income (GOI) minus Gross Operating Expenses (GOE). The NOI that remains is available for paying debt service and paying the owner. Subtracting the Annual Debt Service (ADS) from the NOI calculates the before tax net cash flow to the owner. Dividing the NOI by the property value calculates the Capitalization Rate (CAP). The example has a CAP rate of 10% = $100,000÷$1,000,000. The positive cash flow means that the apartment building is an asset. If the income property was losing money from negative cash flow, then it would be a liability.
The CAP rate is very similar to the yield on a Certificate of Deposit (CD). If you pay all cash for the income property, then the CAP rate is the yield paid to you each year that you own the property.
Real estate is a borrowed money business. An investor will almost never pay all cash out of his own savings account to buy an income property. An investor will use leverage, a combination of debt and equity, to buy income property. The leverage generates Cash on Cash Return (CCR) on the equity investment after servicing the debt.
The Cash on Cash Return (CCR), which I call the Gross Return on Equity (ROE), is simply the before tax net cash flow divided by the equity investment (down payment). Many investors ignore the CAP rate and consider only the ROE. They want to know the yield on their invested cash and compare that yield to other investment opportunities. This is called Option Valuation Theory (OVT). When there are multiple options (choices) of investment opportunities, OVT is the evaluation of the risk versus reward for each option (opportunity). The investor sets an upper limit (minimizing) on risk and a lower limit (maximizing) on reward. When an investment opportunity is found that meets the risk and reward criteria, then the investor chooses that option.
Many investors do not realize that the CAP rate and the ROE yield are directly correlated through three variables:
- Debt Coverage Ratio (DCR): The NOI divided by the Annual Debt Service (ADS).
- Annual Debt Constant (ADC): The ADC is the ADS divided by the initial Debt Present Value (DPV). This number is a blending of the amortization term (the number of periodic payments to fully amortize the debt) and the periodic interest rate to calculate the Periodic Debt Constant (PDC), and then multiplied by the number of periods per year to calculate the ADC. This is also called the Annual Mortgage Constant (AMC) and the Annual Yield Constant (AYC).
- Loan to Value ratio (LTV): The LTV is the DPV divided by the property value or price.
The following equations show the direct correlation of the above three variables:
Annual Debt Constant: ADC (determined by lender)
Loan to Value ratio: LTV (determined by lender)
Equity to Value ratio: ETV = 1 – LTV
Debt Present Value: DPV
Annual Debt Service: ADS
Debt Coverage Ratio: DCR = NOI÷ADS
Debt Coverage Margin: DCM = 1÷DCR
Cash Flow Margin: CFM = 1 – DCM
Leverage to Debt: LTD = LTV÷ETV
Capitalization rate: CAP = DCR×ADC×LTV
Return on Equity: ROE = (DCR – 1)×ADC×LTD
Leverage to Yield: LTY = ROE÷CAP = CFM÷ETV
Maximum Allowable Offer: MAO = NOI÷CAP
Thus, the gross Return on Equity (ROE) is correlated to the capitalization rate (CAP), which is the product of the DCR, ADC, and LTV.
Alternatively, the investor can calculate the CAP rate from the required yields of the investment tranches, such 1st position senior debt, 2nd position preferred equity, and 3rd position common equity. The weighted average of the sum of the products of Position to Value (PTV) and the yield rate:
- 1st position senior debt at 70% PTV with ADC 7.19% (6.00% annual interest rate amortized over 360 months [30 years]).
- 2nd position preferred equity at 20% PTV with AYC 12.50%. This would be the yield for a private money partner or a mezzanine investor.
- 3rd position common equity at 10% PTV with AYC 25.00%. This would be your CCR or ROE yield requirement for your equity investment.
- The combined positions to value (CPTV) is 100% = 70% + 20% + 10%.
AYC = (70%×7.19% + 20%×12.50% + 10%×25.00%)÷(70% + 20% + 10%) = 10.04%
CAP = DCR×AYC×CPTV = 1.00×10.04%×100% = 10.04%
In the above example, the DCR is 1.0 and the CPTV (LTV) is 100%. There is no CCR (ROE), because the property is fully financed (the common equity holders receive 25% yield already factored into the blended AYC rate). Any properties that are offered at less than the calculated CAP 10.04% are priced too high for you to obtain your required yields on your investment tranches. This CAP rate assures that each tranche receives its required yield.
When searching for properties, you can exclude properties that are offered at lower cap rates (higher prices) than what you require for a CAP rate, without bothering to run the income and expense numbers.
I have a more in-depth special report on Strategic Real Estate Investing that is included in my Property Analysis Worksheet Short Form. The report describes how to calculate the various ratios and rates, so that you can structure a deal with 100% financing and positive cash flow. The worksheet is an awesome tool for calculating the Maximum Allowable Offer (MAO) for fix-and-sell or fix-and-rent deals, and it includes mail merge templates for professional 1-page summaries for price justification and financing requests. Check it out now at http://bit.ly/pawsf-1.
Good luck with your investing!