You’ve made it to CRE Financial Analysis 201! Congratulations, Sir Walter Capital would be proud… not too proud… not even proud enough to pat your back… but proud enough not to crush you where you stand. There is still much to learn and cover, much to make Walter proud.
In fact, there’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 you’re counting, and his investment record reflects that. During his investment career, he lost money once – to himself, and both he and his betting counterpart came out on top. Long term planning, diligence and meticulous analysis keep his winning legacy expanding: he’s had a hand in every major discovery since dinosaurs; and he’s capitalized… where do you think the Wal in Walmart comes from?
In investment, there is a holy grail, it’s the concept of arbitrage: taking advantage of a price difference between two or more markets. In Commercial Real Estate specifically, it’s the rate difference between borrowing and earning – the cost of money vs. the return on a property. Arbitrage in CRE is called Positive Leverage.
Positive Leverage: a situation in which borrowing money magnifies your return: using other people’s money (the bank/lender) and paying less to borrow that money than what the purchased property earns.
A brief example of Positive Leverage…
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. If you’re thinking, wait a minute, the cash flow is still greater in the All Cash scenario, you’re right, but you’re forgetting the $700,000 we didn’t need to invest in the Positive Leverage scenario, all of which we could leverage to earn at the higher rate. Sir Walter would be proud, but don’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. An important fundamental element is Newton’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. For shame!
Negative Leverage: a situation in which borrowing money diminishes your return: using other people’s money (the bank/lender) and paying more to borrow that money than what the purchased property earns.
A brief example of Negative Leverage…
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? “Not unless you’re borrowing for your enemies,” Sir Walter said, otherwise he’d be livid, and you’d be considered lucky to be alive.
In order to keep you healthy and full of limbs, we’ve included a FREE PDF that nicely explains the relationship between Positive and Negative leverage. Give it to your clients, employees, or post it over the office urinal. You’re welcome!