The term leverage is used a lot in real estate development finance. It goes back to concepts I’ve discussed in previous blogs, that typical real estate project financing will involve debt because it tends to be cheaper money than equity. To say that another way, the debit has a lower risk profile and therefore demands less return for its use.
When we describe leverage think about how you might use a lever to move a heavy object or to pull a nail. You will use less force to achieve the results you’re after.
Using leverage in a real estate development means you’ll use less of your money, or equity, to achieve the same result. You’ll have additional costs in the form of interest (and fees) so you’ll make less total cash, but the percentage return on the investment increases dramatically. See picture below and explanation that follows. I’ve used simple numbers to illustrate the concept.
The project costs $100, but it costs $105 if you’re going to pay $5 (6.25%) interest for the $80 you’ve borrowed from the bank. The project revenues are the same. You’re building the same product so the market sales price (revenues) will not be affected one bit by how the project was financed. Your total cash return goes down in the bank finance model because you the have the additional costs related to bank borrowing.
But the reason projects use debt is because of the ability to lever that return, to really crank up the % returned on the smaller equity investment. You give up some dollars, and you give up some control due to the bank’s involvement, but if everything goes well the results are tremendous.
This example is simple but is another way to show how real estate development can generate tremendous returns when done right. There is a reason for the term real estate mogul and this principle of generating huge returns on a project show how you get to the level of owning professional sports teams. Commercial and residential real estate development are the same in this regard. Access to bank debt can make or break your ability to get projects done and the ability to generate impressive returns for you as owner or for your investment partners.
Now, leverage can also turn. The Great Recession was the result of leverage gone bad. It’s important to remember that when the project is selling the debt is getting paid off first. Generally the equity is only returned, and the equity return earned, when the debt is gone. The capital stack defines how proceeds are distributed.
If the project does not generate enough cash flow to pay the debt, if project sales are delayed and the interest payments exceed what was planned, if the debt is not paid off in the time frame laid out in the loan docs, it’s easy for problems to snowball. The financial crisis was a result of getting too loose with debt. When the underlying assets were reduced in value in such a way that the debt was silly relative to what supported it, lots of people and businesses got crushed.
Leverage can be very good, but it can also be very bad. Use with caution.
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