positive financial leverage in real estate

Question

I had the understanding that leverage always helped improve cash on cash returns so long as the interest paid was less than the unlevered rate of return/cap rate. doing a quick back of the envelope calculation in excel on first year returns seems to suggest otherwise.

my quick calculations show that there is a spread required from interest rate to cap rate in order to achieve positive first year leverage. It also shows that as amortization tightens the necessary spread increases.

I'm only considering year one one returns with and without leverage, so not taking into account any NOI growth

is my analysis correct here? what am I missing?

my example:

purchase: $7,100,000 cap rate/ unlevered return: 6.99% cash flow: 496,310

if using 80% leverage 30 year debt at 5.75%: payment: 397,763 cash flow: 98,547 cash on cash: 6.94%

if using 80% leverage 25 year debt at 5.75% payment: 428,799 cash flow: 67,511 cash on cash: 4.75%

in both of the examples above I'm using debt that is less expensive than the unlevered return that I'm getting, so why does year one cash on cash suffer?

Answer 1

Alex's post hits the main point: leverage amplifies returns (either positive or negative). In this case, it is not interest rate but loan constant that we should be focusing on. For a \$5.68MM loan (80% of \$7.1MM), the loan constant is 7.55%.

In excel, I used the function: $$PMT(5.75\%/12,30\times12,5680000)\times12$$ to come up with annual debt service of \$496,290 which gives a loan constant of 7.55%.

Thus the annual debt service is dilutive to the yield of 6.99% (and even moreso for the 25-year mortgage).