Youâ€™ve made it to CRE Financial Analysis 201!Â Congratulations, Sir Walter Capital would be proudâ€¦ not too proudâ€¦ not even proud enough to pat your backâ€¦ but proud enough not to crush you where you stand.Â There is still much to learn and cover, much to make Walter proud.
In fact, thereâ€™s no better way to make Walter proud than to flash through a page of his book:
Sir Walter Capital was a man of few faults, no faults if youâ€™re counting, and his investment record reflects that. Â During his investment career, he lost money once â€“ to himself, and both he and his betting counterpart came out on top. Â Long term planning, diligence and meticulous analysis keep his winning legacy expanding: heâ€™s had a hand in every major discovery since dinosaurs; and heâ€™s capitalizedâ€¦ where do you think the Wal in Walmart comes from?
In investment, there is a holy grail, itâ€™s the concept of arbitrage: taking advantage of a price difference between two or more markets. Â In Commercial Real Estate specifically, itâ€™s the rate difference between borrowing and earning â€“ the cost of money vs. the return on a property. Â Arbitrage in CRE is called Positive Leverage.
Positive Leverage: a situation in which borrowing money magnifies your return: using other peopleâ€™s money (the bank/lender) and paying less to borrow that money than what the purchased property earns.
A brief example of Positive Leverageâ€¦
As seen in the example above, when one borrows (6%) at a lower rate than the property returns (7%), a scenario arises in which the investor makes an additional 2.33% on his original investment.Â If youâ€™re thinking, wait a minute, the cash flow is still greater in the All Cash scenario, youâ€™re right, but youâ€™re forgetting the $700,000 we didnâ€™t need to invest in the Positive Leverage scenario, all of which we could leverage to earn at the higher rate.Â Â Sir Walter would be proud, but donâ€™t get carried away.
Recently, I read A Brief History of Time by Stephen Hawking, an exceptional tale of our universe and the laws that govern it. Â An important fundamental element is Newtonâ€™s Laws of Motion: for every action there is an equal and opposite reaction.
Sir Walter might interpret that as: for every intelligent investor, there is an equal and opposite foolish investor, one who might work himself into a scenario of Negative Leverage.Â For shame!
Negative Leverage: a situation in which borrowing money diminishes your return: using other peopleâ€™s money (the bank/lender) and paying more to borrow that money than what the purchased property earns.
A brief example of Negative Leverageâ€¦
Should one borrow (8%) at a higher rate than what the property earns (7%), a scenario with a net loss of 2.33% relative to the All Cash scenario? Â â€œNot unless youâ€™re borrowing for your enemies,â€ Sir Walter said, otherwise heâ€™d be livid, and youâ€™d be considered lucky to be alive.
In order to keep you healthy and full of limbs, weâ€™ve included a FREE PDF that nicely explains the relationship between Positive and Negative leverage. Â Give it to your clients, employees, or post it over the office urinal.Â Youâ€™re welcome!