How Net Lease Investors Use Leverage To Boost Returns And Increase Wealth
Real estate is an attractive investment in its own right. Yet one of the qualities that makes it even more attractive is the ability to use leverage – debt – to further boost the overall return.
Leverage helps savvy investors build tremendous wealth over time by allowing them to increase both their investment return and their buying power. Just as one would use a cash down payment to obtain a mortgage to buy a home, the same applies to commercial real estate investing. Instead of putting down $500,000 cash to buy a duplex, an investor can use that $500,000 as a down payment on a loan on a $1.5M - $2M property. Applying leverage allows an investor to significantly increase their rate of return, in some cases by as much as 50% or more.
The common question people ask with any investment is how much money will I make? A popular metric that investors use to analyze investment performance is the cash-on-cash return. The cash-on-cash return is an annual rate of return that simply divides the cash flow (net operating income before tax) by the amount of cash initially invested. For example, if an investor receives $10,000 in net operating income from a passive investment of $100,000, then the cash-on-cash return is 10%.
One caveat to keep in mind is that cash-on-cash return does not take into account the time value of money, appreciation or the exit value of an investment property when it comes time to sell. Such scenario can be accounted for by other metrics such as the internal rate of return (IRR) and net present value (NPV). Nevertheless, cash-on-cash is a common everyday benchmark used for comparing investment opportunities and performance. So, what’s the difference in potential cash-on-cash return when buying all cash versus applying leverage?
Example: Purchase scenarios for an investment property priced $1M with a cap rate of 7%, which equates to an annual NOI of $70K.
Leverage: The Big 3 Benefits
#1 Amplifying your return
As the above example highlights, the return (cap rate) on the investment property is 7% and you’re paying 4% on the loan. So, you automatically pocket the difference – a 3% profit – using the lender’s money. Looking at the investment through the lens of a cash-on-cash return however, your return is significantly higher at 9.98% (an increase of nearly 42%).
#2 Time – and a tax deduction – on your side
By owning an investment property, you are able to build equity over time. Similar to a home mortgage, the longer you make payments of principal and interest to the lender, the more equity you accrue. At the same time, property appreciation further tilts the equity balance in your favor. The cherry on top is the tax deductions, including depreciation on the asset and interest deductions on the loan payments. All of these perks add up quickly, which is why the ‘wash, rinse, repeat cycle’ of leveraging real estate has proven to be a successful strategy by many for building multi-generational wealth over time.
#3 Scaling up portfolios to build wealth
Leveraging allows you to accumulate more properties than what you could afford compared to buying assets all cash. In the $1M example, the all-cash strategy would get you one asset, whereas leverage would allow you to acquire three $1M properties with a roughly $300,000 starter equity investment in each. This translates to higher cash flow (~$90K vs $70K in the above example). That strategy has cascading benefits with the potential to generate greater cash flow, bigger tax benefits and potentially higher levels of appreciation across three different assets. Additionally, you are not putting all of your eggs, or $1M, in one basket, but instead is diversifying that risk across multiple properties.
Be mindful of investment risk
The potential rewards of real estate investing are enticing. Yet, it is important to remember that no matter how time-tested and proven any strategy is, there is always risk. Leverage works extremely well when property values and rents rise over time. But that is not necessarily always the case. Real estate can be impacted by flat or down economic cycles or market conditions that can affect a tenants’ ability to pay rent, which leaves the investor on the hook to make loan payments or risk defaulting on a loan and losing the asset – and their equity – in a foreclosure situation.
Two of the keys to navigating net lease (NNN) real estate investments are applying careful planning and investing in properties with battle-tested tenants that are thriving even during a pandemic, such as 7-Eleven, Dollar General, Trader Joe's, CVS and others. Whether using leverage or an all-cash strategy, real estate investors who own NNN investment properties backed by strong tenants have shown that they can enjoy outsized returns and still being able to sleep at night. For more information on ways to apply leverage to real estate investments and enjoy your financial freedom, please contact Andrew Vu at 415-539-1120 for a complimentary strategy consultation.